Outline for Federal Income Taxation (Prof.

Gustafsson)
Fall 2006
Blake Gibson
(Keyed to Freeland Lathrope Fourteenth Edition)

1. Orientation (Chapter 1)
A. Orientation
Sections Covered in this Section:

§ 62 – Adjusted Gross Income Defined (p. 49)

§ 63 – Taxable Income Defined (p. 53)
§ 151 – Allowance of Deductions for Personal Exemptions (p. 127)

In General
• “Don’t tax you, don’t tax me, tax the guy behind the tree”
• Holmes – “Taxes are what we pay for a civilized society.
Bradley – “Tax reform is ultimately a decision about values”
• We need to understand tax law for personal benefit and b/c it touches many areas
• Course Scope:
o (1) What is the law?
 How to approach a tax problem (find authority)
o (2) Tax Theory
 If you tax income, you first have to define income
 Are we truly taxing income?
o (3) Tax Policy
 Constantly asking if it meets the desired goals
 You have to balance these three goals:
• Equity – horizontal and vertical
• Efficiency – One type we focus on
• Simplicity
• History:
o First income tax was during the Civil War
o 16th Amendment (1913) – allowed enactment of income tax without being worried about
the CNST concerns of direct vs. indirect
 CNG can levy tax without apportionment
 Enacted same year as Revenue Act
 The prior taxes were export/import tax, excess and use
 Direct tax is a tax demanded from the very person who is intended to pay it (tax
on holding property
 An indirect tax is a tax paid primarily by a person who can shift the burden of the
tax to someone else or who at least is under no legal compulsion to pay the tax.
 The rule of apportionment to which direct taxes must confirm requires that, after
Congress has established a sum to be raised by direct taxation, the sum must be
divided among the states in proportion to their respective populations
 Income tax direct?
• Pollock decision: not in accord with apportionment
• We are responsible for Tax Practioner Tools (pp. 17-29)
• Statutory Scheme:

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 o Subpart B – Computation of Taxable Income
 Part I – Definitions
 Part II – Inclusions
 Part III – Exclusions
o Subtitle  Chapter  Subchapter  Part  Subpart
o § 63 (p. 53) – “for purposes of this subtitle” – Includes all from §1  § 1563
• See p. xi-x for the 2006 Adjustment Items (we have progressive or graduated tax brackets)
o Married, filing separately – rarely good thing to use – maybe if one spouse has large
amount of medical expenses or worried bout husbands filing being bad (fraud) or divorce
prior to filing.
• Title “26 U.S.C.” = “I.R.C.”
• Code Sections not always uniform: Example – Definition of Family:
o § 267(c)(4) – lineal descendents, ancestors, and brothers/sisters
o § 318(a)(1) – Brother/sisters, parents only, and grand parents only
• Two worlds:
o Personal Exemption + § 62 deduction + Itemized deduction (misc. and non-misc.)
o Personal Exemption + § 62 deduction + Standard deduction
• Not on exam: § 68 (gone after 2009) – chips away at itemized deductions for high income earners

Federal Income tax is not the only federal tax (gas, airplane, etc., but it is usually the biggest.
• Property Taxes
o Taxed at the state level
o There is no federal tax for property (apportionment for indirect tax)
 Wouldn’t be valued based on land
 Would have to amend the CNST
o Local level  property tax on real property (although some places like Dallas tax cars
and boats) taxed based on a percentage of property (annually)
• Federal Estate and Gift Tax
o Tired to phase out @ 2010, but will come back in 2011 in it full form w/o CNG action
o The passage was attached to increase in minimum wage (very political, this is a
Democratic goal), b/c the Republicans wanted a lower Federal Estate and Gift Tax (it was
up to 55%)
o The purpose behind this statute is purely political, social purpose – prevent collection of
wealth (note, that it only raised 1% of the Federal Revenue)
o Goal: Wealth Redistribution
o Opponents: Democrats, Warren Buffet, and Bill Gate’s father
• Consumption/Sales Tax
o 9.25% in Tennessee
• Value Added Tax (VAT)
o European tax
o Don’t see the tax at point of sale.
o If you go through borders, you can get VAT refunded
• Excise Tax
o Gas, alcohol, tobacco, etc.
o Airport “user fees” called excise tax sometimes

Social Policy of Taxes:

• Taxes serve more than just revenue purposes – it also serves to regulate
• (1) Raise Revenue
• (2) Effect Social Policy
o Biggest policy furthered is the redistribution of wealth
o Question: How much economic inequity are we going to have?
o Social goals (e.g., encourage charitable giving via deduction)

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 o Tax concept of system = ability to pay (why credit is given for having children)
o Example: § 21, § 45F, § 129 – these credits/exclusions encourage the policy to not leave
kids at home alone (encourage parents to get employed)
o Other Examples of Social Policy influencing:
 § 23 – Adoption Credit ($ amount)
 § 32 – Earned Income Tax Credit
• Tied to low income
• “Refundable tax credit” (Generally, credits are not refundable)
• (3) Influence Economic Activity
o Give specific tax break to those who purchase solar panels
o By raising/lowering taxes
 Not often used
 Long process
 So, now Federal Reserve is most used (over-night loan rates to meet reserve
requirements are changed
• (4) Affect how we allocate resources
o § 41 – Credit for increasing research activities
o § 174 – Deduction for research/experiments
• (5) Affect Natural Resource/Energy Policy
o § 43 – Enhanced Oil Recovery
o § 45(i) – Marginal wells
• (6) Affect Education
o § 25A Hope (Undergraduate, first two years) and Lifetime Learning (need liability) credits
o § 117 – Qualified Scholarship
o § 127 – Educational Assistance
o § 221 – Interest on educational loans
o § 125 – Cafeteria plans
• (7) Affect Environment
o § 30 – Electric Vehicles
o § 24 – Gas
o § 45/45A – Fuels
o § 132(a0 – Encourage mass transit
o §194 – Reforestation
o Superfund liability
• (8) Affect Health Policy
• (9) Assist People Planning for Retirement
• (10) Tax System to Regulate  “Sin Tax”
o Alcohol, tobacco, etc. (Future: McDonald’s tax?)
o Argument against sin tax:
 If goal is to limit, they are paying a lot in taxes, but they place a burden on the
health care.
 They die sooner if you leave them to their sin!! Maybe we should subsidize
smokers and get rid of them? (second hand smoke after all…)

Time Value of Money:

• DEDUCTION TODAY, INCOME IN THE FUTURE
o $ now better than $ 10 years ago.
• Rate of Return – 7%: Doubles every 10 years; 10% -- doubles every 7 years
• Rather pay taxes later than now (rather have tax deduction now)
• READ BOOK: BUSINESS BASICS FOR LAW STUDENTS

Definitions:
• Taxable Income (TI) = Gross Income (GI) – Deductions
• “Above the Line” Deductions = Deductions that get taken out of your Adjusted Gross Inc. (AGI)

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 • Personal Exemptions = §§ 151-152
o Example: dependants
o Tax concept of system = ability to pay
o Built in Equity (Similar to Child Tax Credit)
• Standard Deduction = All other §62 above the line deductions (all others fall in this category)
o Remember, not all deductions are created equal (§ 62).
• Average Rate = Total Income Taxes/Taxable Income
§ 63 – Taxable Income Defined Standard Deductions vs. Itemized Deductions
• § 63(a) (p. 53) – applies to § 1 - § 1563
• § 63(c)(2) – Basic Standard deduction (for 2006 amount see p. xi)
o 200% for married filing jointly -- $ 10,300
o Unmarried: -- $ 5,150
• § 63(c)(3) – Additional deduction for the aged/blind:
o Aged policy: They have a fixed income, so inflation hurts them worse
o Why pick the blind and not the deaf or the mentally retarded??

§ 67 – 2% Floor on Miscellaneous Itemized Deductions

• § 67(a) (p. 56) – Miscellaneous Itemized Deductions – Only 2% of AGI
o $100,000 AGI = Miscellaneous itemized deductions must exceed $ 2,000 to be beneficial
• § 67(b) – Miscellaneous defined

§ 151 – Allowance of Deductions for Personal Exemptions (p. 127)

• Each individual gets to take himself as a dependent on his tax return (§ 151(b))
• § 151(c) – Additional deductions
• § 151(d) – Phase-out and inflation adjustment
o (d)(4) inflation (go to “xi” §3.17) now at  $ 3,300
o (d)(3) Phase-out (take it away as income goes up)
• “xii” – phase-out the portion between the two points
• What is the purpose for adjustment for inflation?
o Income may go up, but purchasing power is not the same (would be paying more, but
dollars are devalued). CNG likes inflation b/c it is built-in revenue raising

THE TAXING FORMULA

Gross Income (GI) (Inclusions: E.g., §§ 61, 71-90)

(Exclusions: E.g., §§ 101-140)

- § 62 Deductions
_______________

Adjustied Gross Income (AGI) (§ 62)

- Personal Exemptions Deduction (§§ 151-152)

- Standard Deduction (§ 63)

OR
- Itemized Deductions (deductions other than those listed in § 62 and the personal
exemptions deduction)
_______________

Taxable Income Rate (§ 63)

X Tax Rates (§ 1 or apply Tax Tables (§ 3))

_______________

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Tax Before Credits

- Tax Credits (§§ 21-53, 6315)

_______________

Final Tax Liability (Unless alternative minimum tax is imposed)

2. Tax Theory and Goals

A. Haig-Simons Definition of Income and Tax Theory
Remember, when the tax law deviates from the H-S definition, we will ask WHY—policy
consideration or loophole (tax break to benefit an important lobbying interest)

Nature and Extent of Existing Tax Subsidies: Tax Expenditure Budget (CB p. 471-473)
• Surrey – Expenditure report required in all reports now (Tax Expenditure Budget)
• Creates Gov’t benefit through the tax code
• Ways to do:
o Give special income preference to certain income through exclusions
o Structural Provision (gets to actual economic income)
 Give deduction (not all are tax expenditures)  Some deductions are necessary:
• Say you sell X for $ 100. It cost you $ 90 to purchase X. Shouldn’t be
taxed on the $ 100, but on the $ 10. This comes from the structural
provisions  cost to produce income tax deduction
• If you gained $ 10, it would be a $15 tax on $100 w/o structural
provisions
• Tax Expenditure Budget: Gov’t forgoing revenue through not collecting  has to be accounted for

Economic Definition of Income:

• Goode Article (GA p. 29): “The H-S definition is a valuable guideline or tax policy and
administration.”
o Used to explain why we change provisions
• H-S defined personal income for tax purpose as “the algebraic sum of (1) the market value of
rights exercised in consumption and (2) the change in the value of the store of property
rights between the beginning and end of the period in question.”
o I = C + EW –BW
o This gets the same answer as GI – Deductions = TI
• C = Consumption (Personal)
• EW = Ending wealth
o Business assets (building) appreciation has upward affect on EW in H-S definition
• BW = Beginning wealth
• EW – BW = what is in your savings

Consumption (Personal):
• (1) Any money you spend during the period for any goods or services and all consumed during
that period
o Distinction between consumption and cost incurred to produce income (not personal)
• Imputed Income: (Helvering v. Ind. Life Comp. – Could be overruled)
o Not included in the tax base for us, but is in H-S tax base

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 o England did include this until 1860 by counting the windows on your house
o (2) Value of Goods you produce and consume during the period
 You grow $ 10 worth of tomatoes, they have a value – include in income
o (3) Value of services you provide for yourself (Barter Transactions)
 If you mowed your lawn – H-S: that’s consumption (income – value to you)
 Includes haircuts and cleaning your own house
o (4) Value of the “use of durable consumer goods” that you possess or own
 Own your own house, then include fair rental value of home in income calculation
 Also applied to cars
 USE BEYOND ONE YEAR
Ending Wealth and Beginning Wealth
• Easy concept
• BW: net worth (add up value of all assets – liability (Balance Sheet) A- L = Equity/Net Worth)
o FMV of assets – liabilities = Net Worth
o EW <> BW at end of period B/C OF TAX
Illustrative Hypothetical for Imputed Income: Is it really fair to leave out for A?
• Two taxpayers: A and B. A spends 1 hour to grow tomatoes in his backyard (assume no cost). A
produces $ 10 worth of tomatoes. B decides to work extra hour at work and get the $ 10 to buy
the tomatoes at a store. In the end, both have $ 10 of tomatoes and both have worked one hour.
• Assume that B has 30% tax rate, so has only $ 7 after tax. Can only buy $ 7 worth of tomatoes.
o Both worked One hour, but B gets $ 7 and A gets $ 10.
o A has imputed income
o Under our system, A would not be taxed on his $ 10 of tomatoes, but under H-S, A would
include the amount in his income b/c of imputed income.
o A has imputed income, but we don’t’ tax on it although A had income under H-S (both
parties had the same goal and the same resulting position pre-tax).

Illustrative Hypothetical for Fairness:

• A uses $ 100,000 to buy a house and B uses $ 100,000 to buy stock in Exxon
• The house and stock stay same (flat market)
• The stock pays a dividend of $ 10,000 (10%) and the house has a fair rental value of $ 10,000
• Fairness of Imputed Income:
o House: Benefit of living in house + consuming something he owns (cheaper)
o Stock: If in the 20% bracket, has to pay $ 2,000 on taxes, so he really only has $ 8,000,
so, he has to rent a lesser house than A.

Illustrative Hypothetical that Barter Transactions Create Income:

• We cannot agree to swap services and not have it viewed as a taxable transaction
• We’d go to a barter economy if we didn’t have this rule
• If we both have $ 100,000 house and rent it to each other for $ 10,000 per year – it would be
taxable income. We could not get away with just trading houses
• However, if we live in our own houses, we have no tax (our system doesn’t have imputed
income). This is a tax break to home owners who live in own house.

Illustrative Hypothetical that H-S is in accord US Tax System:

• I = C + EW – BW = TI = GI – Deductions
• If we earn a $ 100,000 salary and spend:
o $ 20,000 on rent
o $ 8,000 on meals
o $ 25,000 on travel
o $ 5,000 on utilities
o Total = $ 58,000
• Under our tax system = $ 100,000 (GI) - $ 0 (Ded.) = $100K (TI)
• Under H-S, $ 58K (C) + $ 42K (EW) - $ 0 BW = $100K (I)

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 • What if we add, to the above fact pattern, that we have $ 30K of business expenses
o Then, $ 100,000 (GI) - $ 30,000 (Ded.) = $ 70K (TI)
o Then, $ 58K (C) + $ 12K (EW) + $ 0 (BW) = $ 70K (I)

Constitutional Aspects of Taxing

• Direct taxes → must be apportioned
o If Fed Gov’t wanted to raise $10K, each state must contribute its portion according to its
population. From w/in each state → citizens pay based on the States tax base. Result
→ tax base – is what ever the state decides it is and can be different for each state.
o Not a fair way → people making the same amount of $ will pay different amounts of tax
depending on where they live. Someone can have smaller tax base but pay higher % of
income in taxes. Result → income tax cannot be a direct tax – would not be fair
o Property holdings → are a direct tax – so Fed Income tax cannot be based on this b/c
would be subject to rule of apportionment
• Indirect Taxes → are subject to rules of uniformity
• Issue → What kind of tax is the Fed Income Tax? Not answered – Law just says income tax is
not subject to rule of apportionment but rule of uniformity

A. Tax Goals
• The next level of analysis is “Tax Goals” – Is it justifiable? What are the consequences (+ and -)
for deviating from the H-S definition?
o (1) Equity (fairness)
o (2) Efficiency (economic growth)
o (3) Simplicity
• Can the “Why” of deviation from tax theory expectations be answered based on policy goals? If
yes, then the policy goals of tax law make sense of economic theory. If no, then loophole or gift?

Treasury I: (See Handout)

• One of the most important tax documents in history. Reagan wanted specific goals (said this in
his State of the Union address in 1984)  Tax Volume I. This study led to the Tax Reform Act of
1986. However, Treasury I was too offensive, so they came up with Treasury 2 (politically driven
document). Try to get goals (evaluation standards) from this article.
• Bracket Creep
o The need to index taxes for inflation. We have more $, but how are things better.
• Nominal v. Real (Gain)
o You buy something today for $ 100, sell it 5 years from now for $ 150 ($ 50 is your
nominal gain)
o During that period, there was inflation  $ 130 of today’s dollars is equal to $100 five
years ago. The Real Gain is only $20.
o Nominal gain = Real gain + inflation
o Cost of someone forbearing the cost
o Nominal interest rate: interest charge real market rate, paying for use.

(1) Equity
• Our system is that how much you pay is based on your ability to pay.
• (a) Horizontal Income: Two TPs, similarly situated, should pay about the same amount of tax.
o Same income, same tax burden
o However, our tax system gives breaks (things aren’t taxed) which leads to X and Y
making the same, but X being taxed less
o Similarly situated  relative to the tax base
o Example  if two people hold same type of property, should be taxed the same.
o Problem  defining similarly situated
• (b) Vertical Equity: Taxpayers with more wealth should pay more than those with less.

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 o Hypothetical: X’s salary was $100K and he pays 30K in taxes. Y’s income is $50K and
he pays $20K in taxes. Is this vertical equity? No, it is not proportionate to income.
o Is a flat rate equal?
 Then X would pay $40K. Same percentage, but no progressivity (p. 14) (high
income, great tax % paid.
 This is a hot issue: How much progressitivity should there be?
o Ask, why do we have breaks? What policy is being supported/encouraged?
o Progressive Tax Rates – Those who make more should pay more in taxes – more as to
$ amount plus more as to a higher % of their income.
 Ability to pay is sometimes spoken of in the equity policy.
 The idea goes to the value of your marginal dollar
• Is the last dollar of the person who makes $20K more valuable to him
then the last dollar of the person who makes $150K?
• The last dollar of the $20K person might be meant for food
• The last dollar o f the $150K person might be for savings.
• It is a value judgment
o Flat Tax – all TPs pay the same amount; proportional
 The principal is that if you have less $, you will spend less money, so the low
income TP’s taxes will be technically “lesser” then the tax of the high income TP
o Regressive Tax – Example is sales tax
 Income level does not determine level of sales tax
• To make sales tax less R, exempt basic necessities an tax luxuries
• Problem – Complication and enforcement
 Use Tax – Example is purchasing a car in another state, pay no sales tax there,
register the car here, then pay sales tax here. Should work this way for all mail
order purchases, but the problem is enforcement.

(2) Efficiency:
• Economic neutrality = good synonym for efficiency
• Gustafsson has problems with the handling of “economic growth” – more is not necessarily
efficient
• Concept:
o (1) Free Market should allocate
 Without regulation  law of the Jungle (biggest wins)
o (2) Allocation of resources
 Goods/Services  all resources allocated to best use (which is who pays the
most for them) (i.e., lawyers write wills and plumber plumb).
 Really asking here, Is tax law altering allocation of resources to best use?
• Allocation of Resources  What degree or amount of altering free market toward allocation of
resources to best use?
• Resources  labor, capital, natural resources (oil, gas), etc.
• Tension between politicians and Federal Reserve (economic growth can be political or harmful)
• How well does the tax bracket hit its target purpose?
o I.e., move business into impoverished area, but the tax break usually goes to successful
business.
o Intended tax break may have ancillary benefits
• Assume that the market place allocates goods and services to their highest and best use. Look
at the market before you have a tax provision and see how it allocates resources. Then after
imposition of a tax provision, how does the allocation of resources change?
• The more resources shift, we call it more inefficient—it is interfering more with the way the
economic/market system works.
• If a tax provision does not change the allocation of resources—as close to neutral as possible,
then we say it is not inefficient.
• Example:

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 o Anytime you impose a tax, by definition that is inefficient—the resources are taken from
the private sector and put them into the public sector, altering the allocation of resources.
o The reallocation brings in different decision makers who choose how to spend.
• Individual provisions
o All will decrease efficiency because all of them change the allocation of the resources,
assuming that the correct balance and allocation of resources existed and then you
changed it by taxing you have made it inefficient.
o [could say that repealing the provision that created inefficiency is an actual increase of
efficiency—this is theoretical only.]
• Look at labor—all workers are taxed at about the same rate
o Tax salary or wages, not much cost to efficiency
o The taxes do not change people’s decisions when the rates are low
• Natural resources—oil and gas exploration
o Encourage exploration by giving tax breaks.
o Investors take advantage of tax breaks and move their capital from one sector of the
economy to invest in another area.
o This is a reallocation of resources.
o Reduces efficiency because it changes the decisions people make concerning their
resources. Having assumed that all resources were allocated to their best use, then
changing the use of the resources reduces efficiency.
• Other—not important for this course (Promotion of economic growth)
• Regan Era Tax provisions-spurred the economy, resulted in huge deficits
o 1981-ERTA-economic recovery tax act—tax incentives
o 1982-TEFRA-tax equity and economic responsibility act—intended to eliminate or
reduce the tax deficits ERTA produced
• Effectiveness of getting subsidies to intended beneficiaries
o (1) Does the education subsidy aid the student
o (2) Does the subsidy allow the institution to raise prices and thereby take the benefit from
the student.

(3) Simplicity
• Compliance: How simply is it for TP to comply with the tax law?
• Administration: How easy is it to administer tax law?
• Transaction: How much does tax law affect everyday life?
• Rule Complexity – Less Tax Attorneys  we can charge more
• Objectivity in rules (bright lines)

Tax Questions:
• What? Definition, character (most resolved)
• When? Biggest Issue (can I put off having income in the future?
o Time value of money – defer taxes to the future, get deductions now
• Who? Within a family
o Push deductions to higher brackets
o Push income to lower brackets

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 3. Gross Income (Chapter 2)
A. Gross Income Defined § 61
§ 61(a) – In general
• § 61(a) (p. 49) – Gross income = all income (non-exclusive list, just illustrative)
• Defined very broadly  full taxing authority of CNG
• “Otherwise provided in this subtitle” is referring to the exclusion provisions dealt with below
• List not exhaustive → More examples of what is included in income
o Treasure trove – GI in year it is reduced to undisputed possession
o Employer or another person paying TP’s income taxes on wages → the amount paid is
considered additional compensation for services
o Punitive Damages
 Treble damages under antitrust laws
 Exemplary damages for fraud
o Damages paid for Emotional Distress
 That do NOT flow from physical injury → See § 104a2
o Damages for Non-physical personal injuries → See § 104
 Defamation, discrimination, etc.
o Reimbursements in excess of medical costs from employer paid insurance → See §
105a
o Any loan TP has NO intention of paying back
o Gains from illegal activities
o Prizes/awards → See § 74
o Sometime Scholarships → See § 117
o Employer to employee gifts → See § 102
o Reimbursements to employee from employers for employees biz expenses → See Reg
1.62-2
o Gains from gambling → See § 165
• What is NOT income

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 o Any loans you have to pay back
o Mere return of capital
o Interests on state and municipal bonds
o Gifts → See § 102
o Inheritance → See § 102
o Child Support → See → § 71(c)
o Transfers between Spouses → See § 1041
 Including property settlements incident to divorce → See § 1041(c)
o Compensatory Damages for physical injuries → See § 104a2
 Including → emotional damages flowing from physical injuries
o Damages for injuries under worker’s compensation → See § 104a1
o Medical Insurance premium paid by Employer → See §
o Reimbursements in excess of medical costs from employee bought insurance →
See § 104a3
o Employee Fringe Benefits → See § 132
o Sometimes Scholarships → See § 117
o Employee education assistant programs up to $5,250 → See § 127
o Certain employee achievement awards → See § 74
o Group term life insurance paid by employer up to $50K → See § 79
o Gain from Sale of Principle Residence → See § 121
 TP → in past 5 years must have used home as principle residence for at least 2
years or more
 Limits → Gain cannot exceed $250K
• Joint return spouses → cannot exceed $500K

Treasury Regulation § 1.61 (p. 1025)

• Reg § 1.61-1 → Gross income general definition
• Reg § 1.61-2(a)(1) → Compensation for services
o Wages, salaries, commissions paid salesmen, compensation for services on the basis of
a percentage of profits, commissions on insurance premiums, tips, bonuses (Christmas
ones) termination or severance pay, rewards, jury fees, marriage fees, contributions to
clergyman for services, military pay, retirement pay of employees, pensions, retirement
allowances.
• Reg § 1.61-2(d)(1) → Compensation paid other than in cash
o Services are paid for in property – the FMV of the property taken in payment must be
included in income as compensation.
o Services are paid for in exchange for other services – the FMV of such other services
taken in payment must be included in income as compensation
o If services are rendered at stipulated price – such price will be presumed to be the FMV
of the compensation received absent any evidence to contrary
• Reg § 1.61-8(c) → Rents and royalties – expenditures by lessee
o General rule – if lessee pay any of the expenses of his lessor – such payments are
additional rental income of the lessor.
o If lessee places improvements on real estate which constitute, in whole or in part, a
substitute for rent
o Such improvements constitute rental income to lessor
o Whether or not improvements by lessee result in rental income to lessor – depends upon
the intent of the parties
o Which can be indicated either by the terms of the lease or by the surrounding
circumstances
• Reg § 1.61-14(a) → Miscellaneous items of gross income
o Generally – besides the list in § 61 → there are many other types of income.

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Deductions

Above the Line Deductible Items → See § 62a → Code pg. 50

• 1. Trade and Biz expenses → See § 162
o For employers and self employed
 Reasonable Wages paid to employees
 Traveling expenses
 Depreciation on biz equipment → See § 167(a)(1)
 Fees paid to investment advisers
• 2. Certain Trade and Biz deductions of Employees → See § 274
o Reimbursements to employee
 Employee → must take reimbursements into income
o Education/training → to maintain/improve skills of employee or if required by employer as
condition for employment
• 3. Losses from sale or exchange of property
• 4. Deductions attributable to rents and royalties
o Expenses for production of income → § 212
• 10. Alimony → § 215
o Only if alimony taken into income for ex-spouse
• 15. Moving expenses → § 217
• 17. Interest on education loans → §221
• 18. Higher Education Expenses → § 222

• Below the Line Itemized Deductions → 2 types

o § 67 → 12 Non-Miscellaneous Deductions – 100% deductible → See pg. 56 for full list
 1. § 163 Deductions (relating to interest)
 2. § 164 Deductions (relating to taxes)
 3. § 165c Losses → (relating to casualty or theft loses)
 4. §170 Deductions (Charitable contributions)
 5. § 213 Deductions (relating to medical, dental expenses which subject to 7.5%)
 6. Any deduction for impairment-related work expenses
 7. § 691c Deductions (relating to deduction for estate tax in case of income in
respect of the decedent
 If NOT listed on pg. 56 of Code book → then any deductions Code allows are
Miscellaneous and subject to 2% of AGI
o Miscellaneous Deductions → for individual TP → Allowed only to extent the aggregate
of all exceeds 2% of AGI
 Depreciation of property held for production of income → § 167(a)(2)
 § 68 requires high-income taxpayers to reduce the amount of their itemized
deductions by 3% of the excess of their adjusted gross income in excess of an
applicable amount (100K), but not in excess of 80% of the taxpayer’s itemized
deductions

• NOT Deductible
o Personal, living, and family expenses → See § 262
 Rent, food, utilities
 Premiums paid for life insurance
 Costs of insuring personal home
 Costs for traveling away from home → unless qualifies as biz expense § 162
o Child support payments → See § 71(c)
o Loss on personal property → See § 165c
 Includes personal home residence → Reg 1.165-9
o Capital Expenditures → See § 263

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  Any amounts paid for new buildings or for permanent improvements or
betterments made to increase the value of property
 Costs of acquisition, constructing, or erection of buildings, machinery,
equipments, furniture and fixtures, and similar property having a useful life
substantially beyond the taxable year.
 Costs of defending or perfecting title to property
o Carrying Charges → See § 266
o Losses, expenses and interests w/ respect to transaction between related TP’s →
See § 267
o Certain entertainment expenses → See § 274
o Limits on depreciation of Luxury cars → See § 280F
o Losses due to gambling → See § 165d
o Biz Education expenses → to learn new skills

Cases

Cesarini v. United States (6th Cir. 1970) (p. 47)

TP sought to recover income tax payments made on $4,467.00 worth of “treasure” found in a piano
• Held: Treasure-trove is specifically includable as gross income
o “Income from all sources is taxed unless the TP can point to an express exemption.”
• Π’s arguments:
o (1) Not under § 61(a) – the SCT determined that CNG meant to exert full authority under
the 16th Amendment
 Revenue Ruling – Good weight of authority
o (2) (p. 49) Not gift under § 102 (bad lawyering)
 Prizes and awards = part of gross income (applied Dougherty, but misses
completely what the CT held)
 Dougherty
• Net Worth Method – Reconstructing gross income. What you were
worth and what you are worth now  if you cannot show it should be
taxed, you will be taxed
• Neither party cited Reg. § 1.61-14 (p. 1032) – “Treasure trove…constitutes gross income for the
taxable year in which it is reduced to undisputed possession.”
• Statute of limitations argument:
o TP Failed b/c not reduced to possession (that’s when the title vested)
o The key here is reduced to undisputed possession
• H-S applied:
o Should a treasure trove be included? Under H-S, Yes. You either increased wealth or
consumption (simple, efficient, and fair)

Old Colony Trust v. Commissioner (1929) (p. 52)

After an employer had paid his employee’s tax liability, the Gov’t sought to include the amount paid by the
employer as taxable in come to the employee.
• Held: The discharge by a third party of an obligation owed by the TP is an economic benefit to
the taxpayer, and is includable as gross income.
o So long as there is an economic benefit to the TP, the income need not have come into
his possession.
• OCT is executor for Wood’s (CEO) estate
• American Woolen Company paid taxes on behalf of its CEO to the IRS directly.
• IRS is trying to include @ $ 681,000 in gross income in 1919 b/c Wood had an obligation to pay
• Discharge of Liability owed by third party to IRS
o Treats as if money went through Woods to IRS instead of Corporation directly to IRS
o IRS argued that this was additional compensation for services
• If we did not include the $ 681,000 in GI, would be like a deduction for same amount.

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 o Taxes must be calculated on total received
• Illustrative Hypo:
o Income of $100; Tax Liability of $30. If someone pays, then you are taxed on the $30.
So now, next year you have to pay $9, if that is viewed as tax, then $2.70 is added to
your income.
• Formula: Tax on compensation for tax (only works on a flat rate)
o (Amount before Tax) X (Tax rate) = Taxes
o (Amount before Tax) X (1 – Tax Rate) = Amount after taxes
o (Amount before Tax) = (Amount after taxes) / (1 – Tax Rate)
o $100 = 100 / (1 - .30) = $ 143
• This checks out under H-S (should be income):
o Year 1: $100 in salary – I = $0 + $100 – $0 = $100
o Year 2: I = C + EW – BW ($100 I - $30 taxes)
 I = C + EW - $70
 If employer pays tax liability, then income increased by $30
o Year 3: I = C + EW – $100 (less $9 for taxes)
 $9  C + EW - $100 (-$9) = I = $91
• Corporation is only trying to pay the $30 here instead of the actual $43 that is due.
o Here, there would be an under-withholding penalty
• Note: there is no deduction for federal income taxes

Commissioner v. Glenshaw Glass Co (1955) (p. 54)

Glenshaw and Goldman were involved in unrelated anti-trust litigation. As part of a settlement, Glenshaw
received $800,000, of which $324,529.94 represented punitive damages. Glenshaw did not report the
latter amount as income. In its anti-trust suit, Goldman failed to report the punitive amount -- $250,00 –
as taxable income. The Internal Revenue Commissioner sought to recover the deficiencies, but both the
Tax Court and the Court of Appeals found for the TP.
• Punitive damage awards are taxable as gross income.
• SCT definition of income: (p. 57, in singular) – “Here we have an instance of undeniable
accessions to wealth, clearly realized, and over which the TP had complete control.”
• There was no issue about compensatory. They were clearly income.
• This case overruled Eisner v. Macomber which characterized “the gain derived form capital, from
labor, or both combined” as income. (p. 56-7)
o This definition is too narrow
o Took 3 cases to limit Eisner to its facts. The two case after Eisner were Helvering and
Kirby Lumber
o In Eisner v. Macomber → the CT had said a stock dividend was not included into GI.
They held GI was gain derived from capital or labor or both – provided it includes a
severance. b/c a stock dividend is not a severance – it was not a taxable event
o In Kirby Lumber → bonds were issued. Later buys them back after price went down.
They issued them $500 but bought them for less – say $400 - $100 difference. Kirby
Lumber → said no severance so not taxable. CT → said no – was a taxable event b/c
Kirby was better off.
o In Helvering → LL leased land to T – who built a house. T forfeited from non-payment on
mortgage and left….leaving LL the land and the house (which was more $ than the land).
IRS says LL has income in the amount of the house. CT → agreed. Said no severance
necessary.
• Not → LL had problem b/c no $ to pay taxes. Code made change – LL
does not realize the income till he sells the land. Income at the sale –
not at the forfeit.
o Then, Glenshaw

Problem 5 (p. 65): Owner agrees to rent Tenant her lake house for the summer for $4,000.

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 (a) How much income does O realize if she aggress to charge only $1,000 if T makes $3,000 worth
of improvements?
a. $4,000 of taxable gross income to O for rental income (§ 61(a)(5))
i. § 1.61-8(c) (p. 1031) – Expenditures by lessee
b. If tenant does pay the $4,000 in rental in addition to the $3,000 in improvements, what do
you do b/c it is no longer a substitute for the rent?
i. Discussed later (Helvering and §§ 109, 1019)
c. Depends on intent of the parties
d. Here, it is as if the T is Lessee and I.C. (splitting transaction into component parts)
e. Think, if T pays someone cash ($3,000) to do improvements, just like Lessor paid the
$3,000  No, §61(a)(1) Gross Income
(b) Is there a difference in result to Owner in (a), above, if T effects exactly the same improvements
but does all the labor himself and incurs a total cost of only $500?
(c) Are there any tax consequences to Tenant in part (b), above?
a. (1)
i. O ------ (Use of House; FRV $4,000) ---> T
ii. O <----- ($1K cash + $2,500 labor + $500 materials) --- T
b. (2)
i. O --------- ($3,000 cash – FICTION) -----> T
ii. O <------- ($2,500 compensation for services, $500 business expense) --- T
c. Gross Income:
i. (b) O = $3,000 in improvements + $1,000 cash = $ 4,000 rental income
ii. (c) T = $2,500 GI – compensation for services § 61(a)(1)
1. Part Barter/Part Cash. T actually has $3,000 coming into income and a
$500 deduction (business expense § 162(a)) – GI net is at $2,500
Helvering v. Independent Life Ins. Co. (1934) (p. 64) – Income without Receipt of Cash or Property
The Gov’t sought to tax the owner of a building for the rental value of the portion of the building occupied
by the owner.
• Held: The rental value of the building used by the owner does not constitute income within the
meaning of the 16th Amendment
• Imputed Income v. Income in Kind (Barter transaction)
• SCT taking of tax cases is not automatic
o Weighs in on big issues. Needs to be a split among Circuit Courts of Appeals (usually
waits until 2 or 3 on each side).
• We cannot tax imputed income b/c that would not be a direct tax
• Revenue Ruling 79-24 (p. 64)
o If this weren’t subject to taxation, we’d be a complete barter system
o Barter transaction  based on “you can’t catch me.
o Goods for services is income
Dean v. Commissioner (1951) (p. 65)
The Gov’t sought to tax the sole shareholders in a closely-held corporation for the rental value of property
that was held by the corporation, and in which the shareholders lived.
• Held: The fair market value of the residential property that is provided by an employer is to be
included in gross income, even if the employer is the TP’s wholly-owned corporation
• Dean married DuPont (which owned a separate tax paying entity – Nemours Corp.)
• Bank feels unsecured without loans, so H & W transferred house to Corporation so house has
more assets as shareholder (like capital contribution)
• House is now the corporation’s house. No longer H & W’s house. Need to include fair rental
value of rental.
o (H&W)  (Corp./3rd Party Entity)  (H as President of Corp.)
• If Dean didn’t live in house, then corporation could rent (and receive income)
• Services for use (compensation)  Service just way to pay rent
• The corporation is paying a salary, so giving of house could be viewed as more compensation for
services or could call the use of a house as a dividend (not always cash payout).
o Corporation uses as business expense deduction (salary)

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 o Dividend taxed at capital gain tax rate
o Corporation cannot deduct for dividend, but can deduct for payment of salary

H – S  Barter/Imputed Income
• (p. 64) Helvering – We don’t tax imputed income
o This not a barter transaction
o Imputed income is income (if it is a barter transaction)
• If I draft my own will  no tax
o But, if we draft each other’s will, then that is taxable (under our system)
o H-S would say both are taxable
• Both IRC and H-S treat barter transactions as taxable income
• Imputed income and Efficiency:
o If plumber drafts his own will and lawyer fixes his own pipe  imputed income isn’t taxed
o If I draft will, and plumber fixes pipe  taxable.
o Our system encourages inefficiency
• Why don’t we include imputed income?
o Helvering constitutional problem aside (which could be overturned anyway), the main
problem is enforcement and valuation problems
• Rent v. Owning:
o People who rent  pay with after tax $
o Could it be done? Yes, probably easily. Have a formula: FMV x Formula = FRV
o Cannot rely on local assessment
• By not including FRV (b/c it is imputed income), how do we adjust for the owner’s occupying
income? Increase the price
o Have more cash flow. Think of this as a tax subsidy. If good is subsidize  the product
will become more costly.
o People by less  Drop the price
o If CNG decides to tax FRV  PRICES OVERNIGHT WOULD DROP
• House has investment function and consumption
• Taxing on use vs. taxing on FRV? Not question of double taxing, FRV taxing is taxing the return.

4. Gifts and Inheritance (Chapter 3)

Gross income includes the receipt of any financial benefit which is:
• (1) Not a mere return of capital, and
• (2) Not accompanied by a contemporaneously acknowledge obligation to repay, and
• (3) Not excluded by a specific statutory provision

§ 102(a) – Gifts and Inheritance (p. 80)

• Rule: GI does NOT include the value of property acquired by gift, bequest, devise or inheritance
o Value  does NOT matter how large in value it is. You will not be taxed on it.
• See also Reg. §§ 1.102-1 (a) and (b) (p. 1066)
• What is a “gift”?

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 o (1) Duberstein: If it proceeds from a detached and disinterested generosity motivated
by affection, respect, charity or similar feeling. Whether a transfer meets this
standard is a matter of fact to be determined by the DCT
o (2) Employer Gift to Employee: Not a gift. § 102(c) (p. 80)
 What if it was a reward for saving employer’s son life outside of work?
• Still, not a gift.
o (And consider Estate and Gift Tax considerations)
• H-S Definition and Gifts
o By not including the gift in income, (and the donor being taxed already) it avoids a double
tax.
o There is a split here between Haig and Simons. S doesn’t want to tax gifts, but H does
(argument that giving a gift is a form of consumption).
• If kid earns or finds $50 = income. However, if it is a gift, it is not income. Argument that you
should tax gifts outside family grouping. You could shift tax (give deductions) for gifts (donors are
in higher bracket and we’d be giving the money to kids – but, assignment of income not favored).
Also, would lead to the question: is feeding a kid income?
• Bequest (personal property); devise (real property); inheritance (intestate)
o Not income, but don’t necessarily get to exclude it.

Commissioner v. Duberstein (1960) (p. 69)

The Commissioner asked the US SCT to consider two cases which had reached different outcomes in
different circuits. In Duberstein, the TP had received a car from a business associate after providing
useful information, and in Stanton, the TP had received a $20,00 gratuity from his employer upon his
resignation.
• Held: A transfer is a gift, excludable from income under § 102(a) (General income does not
include the value of property acquired by gift, bequest, devise, or inheritance). If it proceeds from
a detached and disinterested generosity motivated by affection, respect, charity or similar
feeling. Whether a transfer meets this standard is a matter of fact to be determined by the
DCT. (p. 72)
o The focus is on intent (Objective standard)
• Duberstein’s argument: B didn’t have the legal obligation to give. B here is detached and
disinterested. Under common law, no legal obligation or consideration.
o SCT said that this was a gift
• Stanton: Remanded to TCT for reason why the money was a gift
• Gustaffson felt that the car was given for referral and not disinterested charity and the $ was
given as a severance
• There was no test adopted by the court. It is an issue of cat to be determined by the trial
court trier of facts. Courts should give great weight to what the tribunal finds.
o Standard of review: Appellate courts can only overturn if trial judge is clearly erroneous
in his findings.
• Frankfurter Dissent: Didn’t like “new language” and Stanton was in no way a gift (judge was
clearly erroneous)

5. Employee Benefits (Chapter 4)

A. Exclusions for Fringe Benefits
§ 132 – Certain Fringe Benefits (p. 107)
• This is the last resort for exclusion of employee income. § 61(a)(1) would include, but for these
exclusions.
• History:
o Enacted in 1984 – goal to give broad guidance and uniformity
o § 132(a) was only (1) – (4) when enacted

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 o The Reg. 1.132-1(b)(3) refers to the new (j)(4) as the old (h)(5)
 (b)(2) – new employee definition & (b)(4)
 Even with wrong cross-reference, the regulation is not invalid.
o Today § 132(h) is old § 132(f)
o Energy Policy Act of 1992
 (h)(4) then (i)(4) then taken away
 Only had (h), now we have (f)
o § 1.32-5(p) is no longer valid (no relevance)
• § 132(o) tells the Reg. to carry out the details
o These regulations have even more weight – Legislative Regulations
o § 7805(a) – general provision granting authority to Reg. (Interpretative Regulations)
 Secretary or his/her delegate (§ 7701(a)9))
• Only applies from employer  employee (sole proprietor cannot use this)
• Why are these excluded? Is there inequity or inefficiency?
• Note the additional benefit of exclusions = no Social Security tax
o Note that more is at stake here than just federal income tax liability. Also included in
income taxes are FICA and SS (7.65% of gross wages up to 15.3%)

§ 79 – Group-Term Life Insurance Purchased for Employees (p. 71)

• Term life insurance: Must die during term to receive anything
• Cash Value Insurance: Investment component
• Premium paid on coverage up to $50K are excluded from employee’s gross income.
• Anything over, is income to the employee
o The policy behind this is to encourage the employees to have life insurance
• H-S: Would include this in TP income
o Why does the code deviate? Probably just too hard to put value on these things
(especially de minimis fringes)
• Example: U of M gives 2.5 times your salary (not all is excluded from income, just the first $50).
Why?
o If you just paid cash to go out and buy the insurance, you would have to use post-tax
dollars. But, here, the policy allows for insurance policy exclusion to provide for families.
If your employer offers it, it encourages more people to get it. Also, it is paternalistic.
o Like S.S.: OASDI  could be the survivor (Old Age Disability Insurance)
 Even squirrels store nuts for the winter.
• Premiums – not included (Tax free fringe benefit)
• GOAL: get more people on insurance (paternalistic)

• (a) Exclusion from gross income → GI shall not include anything that qualifies as a →
o 1. No-additional cost service → Broad employee definition and non-discrimination rule
→ apply §132(a)(1), §132(b), and Reg. § 1.132-2
 Defined → means any service provided by an employer to an employee for use
See §132(h) by such employee if:
for definition of • 1. Such service is offered for sale to customers in the ordinary
employee for course of the line of business of the employer in which the
§132(a)1-2 employee is performing services AND
See §132(j) for
non-discrim.
Requirement 18
for §132(a)1-2
 • 2. The employer incurs no substantial additional cost (including
forgoing revenue) in providing such service to the employee
(determined w/out regard to what employee paid for such service)
o No additional cost → revenue that is forgone b/c the service is
provided to employee rather than paying non-employee
 Same line of Biz requirement → Reg 1.132-4
• If employee does not perform a substantial services in a particular line of
biz – he may not exclude
• Conglomerate → employees who work in a position related to more than
1 biz is eligible for service in all of those.
 If customer is being bumped – and employer is forgoing revenue
• Anything over 20% of cost – is income to employee under QED
 Incidentals → not included
• Maid service, flight attendant, in-flight food
 Reg 1.132-2(a)(3) → still excluded from income – whether service provided at no
charge, reduced charge, partial/total cash rebate
 § 132(i) Reciprocal Agreements → Reg 1.132-2(b)
• Services – must be same type of service
• Must be written agreement
• Neither employer can forgo revenue
• DON’T apply to qualified employee discounts

o 2. Qualified employee discount→ Broad employee definition and non-discrimination

rule → apply. Reciprocal agreements → don’t apply! §132(a)(2), § 132(c), and Reg
1.132-3
 Max of discount → 20%
• Anything over is income
 Same line of biz is required
 Includes insurance policies
 Property discount → employee can get at cost
• Agg Sale Price – Agg cost equals – employee’s discount
Agg Sale Price
 Can be price reduction or rebate

o 3. Working condition fringe → §132a3, §132d, and Reg 1.132-5

 Employee – definition is narrow and non-discrimination ruled doesn’t apply
 Property/Services which would have been deductible to employee as biz
expense or depreciation deduction if not paid for by employer
• Examples → use of company car or airplane for business purposes, an
employer’s subscription to a business periodical for the employee, a
bodyguard provided to an employee for security reasons
• Also → on the job training provided by an employer.

o 4. De minimis fringe →§132a4, §132e, and Reg 1.132-6

 Employee – definition is narrow and non-discrimination ruled doesn’t apply
 Property/service whose value is so small as to make accounting for it
impracticable.
 Considerations → frequency of when offered and value of property/service
• Examples → soft drinks, local telephone calls, coffee, donuts, occasional
party, tickets
 Eating facilities → See §132(e)(2)
-
o 5. Qualified transportation fringe → §132a5, §132f, and Reg 1.132-9
 Employee – def is narrow and non-discrimination ruled doesn’t apply

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 • Highway vehicle → $105/month excluded
• Parking → $205/month excluded
• (reflecting the inflation (p. xi))

o 6. Qualified moving expense reimbursement

 Employee – definition is narrow and non-discrimination ruled doesn’t apply
o 7. Qualified retirement planning services.
 Employee – definition is narrow and non-discrimination ruled doesn’t apply

o §132(j)(4)→ Athletic facilities

 Employee → broad definition and non-discrimination ruled doesn’t apply
 Employees may exclude from GI – value of the use of any on-premises athletic
facility
• Including → gym, pool. Golf course, tennis courts, or other facility
o Can be on premises or operated by employer (if substantially all
facility’s use is by employees)

• § 132(h) → Definition of employees for → §132(a)(1)→ no additional cost service and

§132(a)(2) → qualified employee discount
o Retired and disabled employees and surviving spouse of employee
o Spouse and dependent kids
 Kids → 18 or younger or is student 23 or younger
 Can be stepkids
 Whose both parents are deceased and is 24 or younger

• § 132(j) and Reg 1.132-8→ Nondiscrimination requirement for → §132(a)(1)→ no additional

cost service and §132a2 → qualified employee discount
o Highly compensated employees cannot exclude these from GI
 UNLESS – the same fringe is offered to the rank and file on substantially
the same terms.

Problems (p. 98-99)

Consider whether or to what extent the fringe benefits listed below may be excluded from gross income,
and where possible, support your conclusions with statutory authority

• (a) Employee of National hotel chain stays in one of the chain’s hotels in another town rent-free
while on vacation. The hotel has several empty rooms.
o Answer: All excluded from GI of employee
o § 132(b) – No Additional Costs (p. 107)
 § 132(b)(1) – Same line of business
• See Also: Reg. § 1.132-4 (Line of Business) (p. 1093)
 § 132(b)(2) – No substantial additional cost
• What about cost to clean rooms afterward? Not substantial.
o Reg. 1.132-2(a)(2) (p. 1088)
o Reg. 1.132-2(a)(5)(ii) – Incidental to primary service
o Reg. 1.132-2(c) – Flight attendants charged if reserved seat
 What if Flight attendant flies first class (no reserved seat)
and drinks $50 of alcohol? Not addressed.
• (b) Same as (a), above, except that the desk clerk bounces a paying guest so Employee can
stay rent free. See Reg. §§ 1.132-2(a)(2) and 1.132-2(a)(5).
o Answer: It is included up to FMV or room less 20% (as a Qualified Employee
Discount). (i.e., room costs $100, then $80 is includable in Employee’s income.
o What if the employee were to pay $50 and bumps the paying guest?

20
  $50 is paid, $50 is benefit to employee. $20 (is the maximum and) is still
excluded from income, so $30 is included in income of Employee.
• (c) Same as (a), above, except that the Employee pays the bill and receives a cash rebate from
the chain.
o Answer: Same as (a) – All excluded
o Reg. § 1.321-2(a)(3) – Doesn’t matter if it is a cash rebate.
• (d) Same as (a), above, except that Employee’s spouse and dependent children traveling
without Employee use the room on their vacation.
o Answer: The spouse and dependent are treated as the employee for tax purposes. §
132(h)
o What is the issue? Does family fall under the employee status? Reg. § 1.132-1(b) – Yes.
o What about fact of employee not staying in the room? Not required
• (e) Same as (a), above, except that the Employee stays in the hotel of a rival chain under a
written reciprocal agreement under which employee pays 50% of the normal rate.
o Answer: All $50 is excluded from income.
o Figure out the worse situation first
 Room is $100; pays $50…so, at worst, $50 could be included as GI
o What about if this were the same facts as (b) (QED):
 All would be INCLUDED in income b/c the written reciprocal agreement only
applies to § 132(a)(1).
 See also Reg. 1.132-3(3) (p. 1090)
• (f) Same as (a), above, except that Employee is an officer in the hotel chain and rent-free use is
proved only to officers of the chain and all other employees pay 60% of the normal rate.
o Answer: $100 is included in income
o (1) Is officer highly compensated employee?
 If so, anti-discrimination rules apply here.
 Defined in Reg. § 1.132-8(f) (p. 1099) and also in § 414(g),(s),(t)
 Assume here that he is.
o (2) Is it substantially the same terms?
 No.
o (3) What is the discriminatory amount?
 Immaterial under 1.132-8. ALL BENEFIT IS LOST IF PLAN IS
DISCRIMINATORY
o See Reg. § 132-2(a)(4); § 132(j)
• (g) Hotel chain is owned by a conglomerate which also owns a shipping line. The facts are the
same as in (a), above, except hat the Employee works for the shipping line.
o Answer: All of the amount is includable b/c it is not in the same line.
o Line of business limitation applies to both §§ 132(a)(1) and (2)
• (h) Same as (g), above, except that Employee is comptroller of the conglomerate.
o Answer: All is excludable
o See Reg. § 1.132-4(a)(1)(iv) (p. 1093)
• (i) Employee sells insurance and employer Insurance Company allows Employee 20% off the
$1,000 cost of the policy.
o Answer: All is included.
o This does not fall under the “No-Additional Cost” b/c it costs the employer something
• (j) Employee is a salesman in a home electronics appliance store. The prior year the store had
$1,000,000 in sales and a $600,000 cost of goods sold. Employee buys a $2,00 video cassette
recorder from Employer for $1,000.
o VCR, so use the property formula
o Gross Profit % = (ASP – COST) / ASP
o Gross Profit % = ($1,000,000 - $600,000) / ($1,000,000)
 40%
o So, here the Qualified Employee Discount is up to 40% (or $800 of $2000 VCR), so $800
is excluded under QED; $200 is included in Gross Income

21
 o Reg. § 1.132-3(e) – Excess Discounts
o The result is that employee can buy at cost
• (k) Employee attends a business convention in another town. Employer picks up Employee’s
cost.
o Answer: The full amount is allowed as a deduction under either § 162 or § 167.
o This falls under the “Working Condition” -- § 132(d)
 § 162, business expenses are deductible if they are ordinary and necessary and
occurred during trade or business
• If sole proprietor = trade
• If associate = trade or business
 § 167 – Depreciation
o Problem with this problem is that it is employer’s expense. Limit application – would have
to say it was the expense of employee.
o Why have § 132(d)?
 Rationale: treat as wash (not really wash though b/c not all people take itemized
deductions.
 § 62(a) – employees are itemized deductions (miscellaneous) subject to 2% floor
• (l) Employer has a bar and provides the employees with happy hour cocktails at the end of each
week’s work
o Answer: Not clear…based on frequency, it may be included.
o § 132(e)(1) – Not clear cut rule
o Two reasons why the rule is vague:
 (1) Cannot imagine all situations
 (2) Gives IRS flexibility to challenge TP
o Focus is on frequency:
 § 1.132-6(b)(1) – One employer gets drink every day
 § 1.132-6(b)(2) – All employees
o Can look here at Revenue Rules or Personal Letter Rulings
 PLR are online.
 § 6110 – Cannot rely on other’s rulings, but CT not to harsh on that. IRS though
not bound to this position (not high level people issuing these opinions).
o Challenges are resolved at the administration level (that’s why not much info for de
minimis fringe benefits)
• (m) Employer gives Employees a case of scotch each Christmas.
o Answer: Problem here is how much is the Scotch worth. Cash would be taxable, but if
this is a high value…could be taxable as well.
o You can give a turkey at holiday time…but what if it is flown in?
o Reg. § 1.132-6(e)(1)
• (n) Employee is an officer of corporation which pays Employee’s parking fees at a lot one block
from the corporate HQ. Non-officers pay their own parking fees. Assume there is no post-2001
inflation.
o Answer: All is excluded.
o Discriminatory rule not applicable here.
o § 132(f)(6) sets the rate (after 2006 adjustment) at $ 205/month (p. xi)
• (o) Employer provides Employee with $110 worth of vouchers each month for commuting on a
public mass transit system. Assume there is no post-2001 inflation.
o Answer: The amount above the § 132(f) limit is taxable.
• (p) Employer puts a gym at the business facilities for the use of the employees and their families.
o Answer: All is excluded (§ 132(j)(4)

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 B. Exclusions for Meals and Lodging
§ 119(a) – Meals or Lodging Furnished for the Convenience of the Employer (p. 95)
• Meals:
o (1) For the convenience of the Employer
o (2) Furnished on the business premises
• Lodging: (i.e., hotel manager living on site)
o (1) Convenience of the employer
o (2) Lodging on the business premises
o (3) As a condition of employment
• Reg. § 1.119-1 (p. 1073)

§ 107 – Rental Value of Parsonages (p. 84)

• See CB p. 102, Fn. 8 – Jewish Cantor was given exclusion b/c he had “duties essentially the
same as a minister in non-Jewish faith”
• In the case of a minister of the gospel, GI does not include –
o (1) The rental value of a home furnished to him as part of his compensation
o (2) The rental allowance paid to him as part of his compensation, to the extent used by
him to rent or provide a home and to the extent such allowance does not exceed the FRV
of the home, including furnishings and appurtenances such as a garage, plus the cost of
utilities.

23
 6. Awards (Chapter 5)
A. Prizes
§ 74 – Prizes and Awards (p. 70)
• (a) General rule – GI includes amounts received as prizes and awards
• (b) Exceptions for certain prizes and awards transferred to charities:
o Made primarily in recognition of religious, charitable, scientific, educational, artistic,
literary, or civic achievement, but only if:
 (1) No action by recipient
 (2) No substantial future services by recipient
 (3) You cannot keep it
• (c) – NOT ON EXAM
o Employee achievement awards
o (see also § 274(j) – retirement or safety-on-the-job awards)

24
 B. Scholarships and Fellowships
• Can be taxable and non-taxable: See § 61(a)(3)

§ 127 – Educational Assistance Programs (up to $5,250 per year) (not on exam)
• Employee does not included into GI money spent by employer for educational assistance to the
employee
o Limit $5,250
o Generally does not included graduate school
o Cannot discriminated for highly paid employees
 Includes tuition, books supplies
 Does not include sports, games, hobbies
o See p. 102

§ 117 – Qualified Scholarships (p. 93)

• (a) Rule: GI does not include any amount received as a Qualified Scholarship
o Qualified Scholarship is any amount received that is used for qualified tuition and
related expenses
 Which include:
• Tuition and fees for enrollment or attendance
• Fees, books, supplies, and equipment (required – if only
recommended, then not excluded)
 Which does NOT include:
• Room and Board (any $ that goes to room and board is income to the
student)
• (c) Limitation:
o Money received which represents payment for teaching, research or other services
by the student which is required as a condition for receiving the scholarship
 If scholarship is conditioned on past or future teaching/research –
represents payment for services.
o What if all students in department are required to work/research to obtain degree?
 As long as the student is required to perform for the scholarship – is payment for
services.
o If Student has $6000 scholarship and has to work – and other non scholarship students
receive $2000 for similar services – than Student has to claim $2000 for income b/c this
represents payment for services
 If Student can show other $4000 is qualified tuition – then excluded
• (d) Qualified Tuition Reduction
o Rule: GI does not include this
o Tuition reduction: Reduction in tuition provided to an employee or family member of
employee (See § 132(H) for definition of employee)
o Cannot discriminate in favor of highly paid employees
o ONLY APPLIES TO UNDERGRADUATES
 But, § 117(d)(5) allows for teaching and research assistants at graduated level

Problem (p. 112) –

(1) Student working toward an A.B. degree is awarded a scholarship of $15,000 for full tuition and for
room and board during the academic year. The tuition, including the costs of books, is $10,000, and the
room and board costs $5,000. As a scholarship recipient, Student is required to do about 300 hours of

25
research for the professor to whom he is assigned. Non-scholarship students, if hired, receive $10.00 per
hour for such work.

• (a) What tax consequence to Student?

o Value of services for research is $3,000
o Cost of room and board is $5,000
o Cost of tuition is $10,000
o Issue: Whether you apply the $3,000 in research to the room and board or Tuition and
books –
o Student’s income = $3,000
 § 117 room and board – not excluded from income – only tuition
 See also Reg § 1.117-6(c)
 Note → if services applied to tuition – books – then there would be NO
qualified scholarship!
• BUT → IRS lets you choose were to put that money –
• Here – Student would say the services is designated to the room
and board
o Gives $3000 income
o What if Students are paid $30 for an hour of research?
 The maximum amount excluded then would be $6,000 (b/c $9,000 for $30/hour
times 300 hours)
• (b) What tax consequences to Student if all students are required to do 300 hours of research for
faculty?
o Reg. 1.117-6(d)(1) – Anything that represents payment for teaching/research is part of GI
regardless of whether all candidates for the degree are required to perform such services
• (c) What result if Student is not required to do any research but receives the $15,000 as an
athletic scholarship?
o Athletic scholars are given a break. (See CB p. 111)
• (d) What tax consequences to Student if Student receives only a tuition scholarship worth $9,000
(no books) b/c Student’s spouse is an employee at a neighboring educational institution and the
tuition scholarship is part of a nondiscriminatory plan between the several institutions applicable
to all employees of such institutions?
o § 117(d) Qualified Tuition Reduction – ½ is deducted
o § 117(d)(2) – Conditions:
 Employee
 Educational organization
 Below graduate level
 Doesn’t apply to books (just tuition)
• Hypo:
o Law School Scholarship:
 Reduction in tuition + stipend. By working, you become an employee so (d)
doesn’t apply for services.
 If the tuitions is 10,000 and you get ½ tuition + $5,500 ($3,000 services)
• $3,000 is taxable and $2500  tuition, not taxable
 Required books can be covered by excess?
• See BC for policy

26
 7. Gain from Dealings in Property (Chapter 6)
A. Determination of Basis
§ 61(a)(3) – GI includes gains derived from dealings in property (p. 49)
• If you buy a car for $10,000 and sell it for $15,000 you have a gain of $5,000 and that is GI
o $10,000 is the Adjusted Basis (AB)
o $15,000 is the Amount Realized (AR)
o And $5,000 is the Gain (or (Loss) depending)
• If you sell care for $5,000, then you have a loss, but it is not deductible b/c it is a personal car
• Reg. says go to § 1001(a)

§ 165 – Losses (p. 152)

• (a) – General rule: there shall be allowed as a deduction any loss sustained during the taxable
year and not compensated for by insurance or otherwise
• (c) – Gatekeeper (if you cannot get it through here, you cannot get it at all)
o (1) Loss in trade or business
o (2) Transaction entered into for profit
o (3) Casualty (i.e., Hurricane hit and you have no insurance) (not really covered in exam)
property not connected w/ a trade or biz – is such loss is from fire, storm, theft. Must be
more than $100 and must exceed 10% of AGI (so if AGI is $60K – no deduction allowed
for 1st $6000)
• (h) – Not covered in this course

§ 1001 – Determination of Amount of and Recognition of Gain or Loss (p. 511)

• (a) § 1001 and Reg. § 1.1001-1(a) (p. 1746)  Determining amount of and recognition of G or (L)
o Gain from the sale or other disposition (which includes abandonment) of property
shall be the excess of the amount realized therefrom over the AB provided in § 1011 for
determining G, and the loss shall be the excess of the AB provided in such section for
determining loss over the AR.
o Computing G(L) = AR – AB = G(L)
• (b) – Realized (means the sum of money received and the sum of the property received)
o Probably not responsible for rest of § on exam
o AR =
 Any cash received + FMV of any property received plus
 All debt given up (§ 1017  discharge of indebtedness)
• (c) – Recognized (means you take it on your tax return)
o Except as otherwise provided in this subtitle, the entire amount of the gain or loss,
determined under this section, on the sale or exchange of property shall be recognized.

Adjusted Basis – 3 sections: (pp. 512, 515)

• § 1012 – Basis of Property – Cost: The Basis of property shall be the cost of such property
• § 1011 – Adjusted Basis for Determining Gain or Loss
o TP’s basis +/- any adjustments = AB
o Adjustments can be effected by both depreciation and capital expenditures

27
 • § 1016 – Adjustments to Basis
o § 1016(a) – Proper adjustment in respect of the property shall in all cases be made for
 (1) Expenditures
• Line between capital expenditure and repair
o Replace roof = add to basis
o Put back on roof three shingles – not considered improvement
 Not properly chargeable to the capital account
 Consistent with § 1016 See §1.1016-2 (p. 1762)
o § 263(a)(2) – restoring/making good exhaustion
 (2) Depreciation (covered later)  theory – matches expenses to revenue the
asset helped create
• Even if TP doesn’t take depreciation, IRS will still consider it when sold.
TP just hurting himself—so needs to take depreciation
o § 1.1016-2(a) (p. 1762) – Items not properly chargeable to capital account
 No double dipping – cannot also take deduction
 If you take deduction, you cannot add it to the basis
• The one exception is property taxes (RARE)
 You have a choice: deduct or add to basis
• Goal is to get high basis
 Expense
• Minimize tax liability now (vs. later)
• Prefer deductions over addition to basis for non-depreciable asset (same
preference for depreciation)
 Capital Expenditure
• Not deductible expense
• Adds to basis
• Hypothetical:
o You own your own personal residence. You lose two shingles, but no deduction (b/c
personal expenses are not deductible). You replace the whole roof, adds to basis.
Would you prefer something to be a repair or a capital expenditure? Capital Expenditure
here (b/c it is a gain to cost basis).
o If you were renting, you would prefer a business expense (deduction now)

§ 109 and § 1019 → work together to explain a Landlord’s AB in property he leases when the
tenant improves the property.

• §109 → Improvements by lessee on lessor’s property → GI does not include income (other
than rent) derived by lessor of real property on the termination of a lease, representing the
value of such property attributable to buildings erected or other improvements made by
the lessee
o So → if Lessee makes improvements → TP lessor does NOT include the value of such
improvements into GI when lease is up.
 If Lessee makes improvements in lieu of rent → lessor should include as GI
b/c it is rent.
• Plus → amount of the value of the improvements taken into income
as rent – is added to lessor’s basis – as if he used the rent money
and made the improvements himself.

• §1019 → Property on which Lessee has made improvements → if §109 excludes value of
improvements from lessor’s GI → TP does not increase basis on forfeiture of the property.
He will be taxed on the improvement when he sells it.
o So → if lessee is paying rent and adds $2000 improvements to house
 TP lessor → does NOT have to take into income.

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  TP lessor – does NOT add this $2K to his AB – b/c when he sells it he will be
taxed on the $2K then.
 If he added it to his AB → he will not be taxed on it 

• So → Code says if §109 excludes improvements from income → then §1019 says you
cannot add it to your basis or else TP double dipping.

o Gus’s Hypo to explain

 LL has $10K AB in land. Tenant puts in $400K building and forfeits lease.
• LL does NOT have to include the $400K as income (would be hard for
lots of people to pay this)
• LL sells → for $410K
o LL’s gain = AR $410K — AB $10K = $400K
• LL → CANNOT add the $400K to his AB
o He has to be taxed on it sometime.

o Change facts
 Says FMRV of land is $1400/year. Tenant pay $1000/year and making $400 in
improvements
• Reg 1.61-8(c) → says this is rental income
• BUT → the $400 of improvements → IS added to lessor’s basis
o So he wont be taxed twice on it 
 So → after 5 years of the $400/year improvements
• Lessor has an AB of $12K in property

Philadelphia Park v. US (1954) (p. 115)

• TP had 50 year franchise to operate passenger railway. TP owned the bridge. TP exchanged
the bridge for an extension on franchise and with 3 years left → abandoned it. TP asserted
depreciation deductions based on the cost of the extension and a loss upon abandonment of the
franchise.
o Issue → what was TP’s basis in the franchise at time of abandonment?
o CT  TP abandoned – so AR is = to 0 (So whatever TP’s AB in property is will
determine the G(L))
o What is the AB of the bridge?
 Generally → AB in property received is its FMV
• What if it is hard to determine as it is here?
 If Property is received in exchange for property
• Value of 2 properties in arms length transaction- are deemed to be
equal
 CT → said this was an exchange between Park and the city
• Park gave bridge to city and city gave Park the franchise extension

Rule → Basis is the FMV of what is received in an exchange .

• Here → the FMV of the 10 year extension is hard to determine
o If you cant determine the value of the extension – look at the value of what it was
exchanged for.
 Will presume franchise is = to the Bridge (what it was exchanged for)
 Bridge → has a value. CT said to find the FMV of the bridge and you will have
the FMV of the extension and thus
• You have the TP’s AB in the franchise extension.
o Why was IRS mad?
 The original exchange was a disposition of property for TP that they never got
taxed on. They don’t want TP to now get a loss.
• Gus’s Hypo’s → what happens if exchange of property does NOT have = FMV?

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 o Exchange #1 →
 A owns land AB = $8K FMV = $12K
 A exchanges land for rug w/ FMV = $11K
 A’s G/L on disposition of land
• AR $11K — AB $8K = $3K Gain
o Exchange #2 →
 A sells rug for $13K
 How do you calculate A’s G/L? What AB do you use for the rug????
• AR $13K — AB $11K = $2K Gain
 Look to the value of what A received to get the AB
• Here → is the FMV of the rug

• Change facts
o Exchange 1 →
 FMV of rug = $11K
 FMV of land = $10K
 AB in land = $8K
• A exchanges → AR $11K — AB $8K = $3K gain
o Exchange 2 →
 AR $13K — AB $11K = $2K gain
• If used the FMV of the land – would be WRONG!
• Rule → In determining AB for property received in an exchange →
o Must use FMV of property received
o Only if you cannot ascertain the FMV of the property received may you presume
the FMV is = to the property in which it was exchanged for!

Problems (p. 118):

Owner purchases some land for $10,000 and later sales it for $16,000.

• (a) Determine the amount of Owner’s gain on the sale

o $ 6,000 gain on sale
• (b) What difference in result in (a), above, if O purchased the land by paying $1,000 for an option
to purchase the land for an additional $9,000 and subsequently exercised the option
o Acquired through $1,000 + $9,000 (exercise price of $9,000 which is part of cost of land)
o Basis is $10,000 if exercised
o $6,000 Gain
o What if option lapses?
 $1,000 loss under § 165(c)(2) maybe
• (c) What result to O in (b), above, if rather than ever actually acquiring the land O sold the option
to Investor for $1,500
o Option = intangible
o Sale results in $ 500 gain
• (d) What difference in result in (a), above, if Owner purchased the land by making a $2,000 cash
payment from Owner’s funds and an $8,000 payment by borrowing $8,000 from the bank in a
recourse mortgage (on which O is personally liable)?
o The idea is that cost = what you are paying (doesn’t matter that it is a loan)
o Basis = $10,000 (Gain is $6,000)
o Recourse vs. nonrecourse = no difference here. The problem arises if nonrecourse
> FMV (See Crane v. Tubbs)
 Nonrecourse: Only property securing the debt
 Recourse: Property 1st, then other assets of debtor

30
 o The interest on loan does not effect the basis. The issue here is whether the
interest itself is deductible as a “cost for the use of money” under § 163.
o § 1.1001-2(2) and § 61(a)(12)
• (e) What result in (a), above, if O purchased the land for $10,000, spent $2,000 in clearing the
land prior to its sale, and sold it for $18,000.
o Adjustment to basis under § 1016. So, AB = $12,000 and AR = $18,000, so $6,000
Gain
• (f) What difference in result in (a), above, if O had previously rented the land to Lessee for five
years for $1,000 per year cash rental and permitted Lessee to expend $2,000 clearing the
property? Assume that, although O properly reported the cash rental payments as GI, the $2,000
expenditures were properly excluded under § 109. See § 1019.
o $ 2,000 clearing land was not a substitute for rent.
o P. 63 5(a) – Say landlord rented property to T for $5,000
 T pays $1,000 in rent and gives $5,000 in improvements.
 LL has income of $4,000 (which is added to his AB of his property)
• If $4,000 NOT for rent—Improvements are NOT added to AB
• Will be taxed on them when he sales them
 If O pays I.C. $3,000 for improvements, O must add $3,000 to his AB and IC
must report $3,000 in income.
• (g) What difference in result in (a), above, if when the land had a value of $10,000, O, a real
estate salesperson, received it from employer as a bonus for putting together a major real estate
development, and Owner’s income tax was increased $3,000 by reason of the receipt of the
land?
o Same as (a) = $6,000 gain
o O’s tax increase is a result of earning income. NO CONNECTION TO LAND
• (h) What difference if O is a salesperson in an art gallery and O purchases a $10,000 painting
from the art gallery, but is required to pay only $9,000 for it (instead of $10,000 because O is
allowed a 10% employee discount which is excluded from GI under § 132(a)(2)), and O later sells
the painting for $16,000
o Answer: AR $16K, AB = 10K, G = 6K
o Under § 1012, basis = cost…But if you used AB of $9, you would wipe out the employee
discount which he is NOT supposed to be taxed on. Would allow § 1012 to hurt § 132(a)
o So, use FMV of time when he bought to preserve employee discount

Problem 2 (p. 119)

In an arm’s-length exchange, Sharp exchanges some land with a cost basis of $6,000 and a value of
$9,000 with Dull for some non-publicly traded stock which Dull owns and in which Dull has a basis of
$8,000 and is worth $10,000 at the time of the exchange.

• (a) Consider S and D’s gains on the exchange and their respective cost bases in the assets they
receive
o S AR = 0; AB = 10K  4K gain
 CB = 10K
o D AR = 9, AB = 8  1K gain
 CB = 9K
• (b) What results in (a), above, if the value of Dull’s stock cannot be determined with any
reasonable certainty.
o The point is that an arm’s-length transaction – it is presumed that one item is equal in
value to that of the other item being exchanged.
o S gained 3K; D gained 1K (each has a CB of 9K)

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 B. Property Acquired by Gift
• Not a taxable event for Donee. For Donee’s basis in property →
o Determining G → Use Donor’s Basis (Step in their shoes)
o Determining L → Use whichever is less → FMV or Donor’s Basis at time of gift

- § 1015a and Reg 1.1015-1(a) → Donee’s basis of property acquired by gifts

o Basis shall be the same as it would be in the hands of the donor
 Or basis for last person who acquired it in a taxable transaction.
 Follow trail of ownership to someone who had a cost in it and did not acquire by
gift.
o Except that if such basis is greater than the FMV of the property at the time of the gift
 For determining loss – basis shall be FMV.
o Why? → Code allows TP’s to shift gains but not losses built in at time of gift.
 Moral → don’t give away property that has BIL
 Most gifts are between family members, this goal is to discourage passing to high
tax bracket person the less
o If gift is cash → value of cash is the AB

- Tweener situations → where Donee will have NO gain or loss

o If property has FMV of $20K at time of gift and Donor’s basis is $30K
 If Donee sells between $20K and $30 → Donee has no gain or loss

Part Sale/Part Gift Reg 1.1001-1(e) for Transferor (p. 1748) Reg 1.1015-4 for Transferee (p. 1761)

- Reg 1.1001-1(e) → Transfers in part a sale and in part a gift

o Transferor has a gain to the extent that the AR by him exceeds his AB in the
property.
 However → no loss is sustained on such a transfer if the AR is less than
the AB

- Reg 1.1015-4 → Transfers in part a sale and in part a gift

o The unadjusted basis of the property in the hands of the transferee
 1. Whichever of the following is the greater:

32
 • a. The amount paid by the transferee for the property or
• b. The transferor’s adjusted basis for the property at the time of the
transfer
o for determining LOSS – same as gift situation (use lesser of
FMV or donor’s AB)

• Straight gift → Donor will not recognize neither a G or L

o All gain shifts to donee
o Cannot shift loss – will loose any BIL (donee takes FMV basis for BIL)
• Part gift / part sale → Donor can recognize a Gain
o Donor cannot recognize a Loss!
• Tweener situations → still produces no gain or loss.

Taft v. Bowers (1929) (p. 119)

A donee of stock sought to recover income taxes paid on the amount the stock appreciated while in the
hands of the donor.
• The CNST does not prevent CNG from treating as taxable income to the recipient of a gift the
increase in the value of the gift while it was owned by the donor.
• See Hypo on top of CB p. 120
• At issue: What is the AB?
• CT: Revenue law provided that on a gift, no tax reported – but, it will not be wiped out. Gift is not
a realization event under § 1001(a). No § that says you don’t recognize gain/loss to the donor
b/c gift is not a realization event.

Problems (p. 125)

(1) Donor gave Donee property under circumstances that required no payment of gift tax. What gain or
loss to Donee on the subsequent sale of property if:

• (a) The property had cost Donor $20,000, had a FMV of $30,000 at the time of gift, and Donee
sold it for: Basis is the same as in the hands of donor (AB = $20,000)
o (1) $35,000
 Gain of $15,000
o (2) $15,000
 Loss of $5,000
o (3) $25,000
 Gain of $10,000
• (b) The property had cost Donor $30,000, had a $20,000 FMV at the time of gift, and Donee sold
it for: (30K AB to Donor, 20K FMV at time of gift; 10K BIL)
o In gift with a BIL, use the FMV at the time of gift. IRS does not allow shifting of the loss.
o Note: donor who gives away property that has a BIL gives away the loss for tax purposes
and loses the opportunity to claim the loss to offset other income.
o NO amount of BIL will ever be recognized in a gift transfer. Tax planning strategy to
recognize is to sell the asset and transfer the proceeds to the donee.
o (1) $35,000
 Since there is no loss here, use the general formula – step in the shoes
 AR = 35K
 AB = 30K
 G = 5K (for tax purposes, although there is a 15K economic gain)
o (2) $15,000
 To determine loss: FMV at time of gift
 AR = 15K
 AB = 20K
 L = 5K

33
 o (3) $24,000
 Figure it both ways:
• To determine gain:
o 24K AR
o 30K AB (Donor’s basis)
o 6,000 loss
• To determine loss:
o 24K AR
o 20K AB
o 4,000 gain
 General rule: Any sale that brings in an amount in between the FMV at time
of gift and the Donor’s AB results in no gain and no loss.

(2) Father had some land that he had purchased for $120,000 but which had increased in value to
$200,000. He transferred it to Daughter for $150,000 in cash in a transaction properly identified as in part
a gift and in part a sale.

• (a) What gain to F and what basis to D under Reg. §§ 1.1001-1(e) and §1.1015-4(a)(1)?
o F (§ 1.1001-1(e), p. 1748)
 $150K AR
 $120K AB
 $30K Gain -- § 1001(a) Realized and recognized
o D (§ 1.1015-4(a)(1), p. 1761)
 150K b/c that would preserve the 50K BIL
 § 1.1015-4 agrees
o HYPO: What if D paid only $90,000 in cash?
 F would have a 30K realized, but not recognized loss.
 D would have an adjusted basis of 120K
 Analysis:
• (1) Part Sale/Part Gift (less than FMV)
• (2) BIL = 80K
• (3) 110 L (but not recognized)
• (4) For D  greater of $90 or $120
• See BC for more permutations (p. 53)
• Now (a) again, this time applying § 267 – Losses, Expenses, and Interest with Respect to
Transactions Between Related Taxpayers (p. 242).
o Rule produces the same affect when property has BIL (gift of loss property = loss
disappears). So here, if D turns around and sells, then we use the
o § 267 Flow Chart
 Father had some land that he had purchased for $120,000 but which had
decreased in value to $100,000. He transferred it to Daughter for $100,000 in
cash in a transaction properly identified as in part a gift and in part a sale.
 (1) Is it § 1001(a) realized loss?
 (2) Is it § 1001(c) recognized loss?
 (3) Does it qualify under § 167(c)?
• Last hurdle to claim loss, must be:
• Business/trade
• Transaction entered into for profits (stocks, etc)
• Casualty (not covered)
 (4) § 267 – Stops the loss
• § 267 fits under the “except as otherwise provided” language -- § 267(a),
(b) disallows this loss because the transfer is father and the transferee is
daughter.
• Focus on § 267(d)(1) – F cannot take loss

34
  (5) What basis will D take?
• § 267(d) applies to the later sale by D. Amount of gain where loss
previously disallowed. If the loss sustained by the transferor was
disallowed under § 267(a)(1) and TP sells or disposes of the property at
a gain, the gain is recognized only to the extent is more than the loss
disallowed to the donor/relation
• If in the in between situation, no gain and no loss to D
• If sold for a gain, only can take gain to the extent it exceeds loss
• Any AR on a later sale below the FMV at the time of gift from
relative (i.e., loss on donee’s watch) then it is a recognized loss
 SEE BC FOR PREMUTATIONS OF THIS §

• (b) Father had some land that he had purchased for $120,000 but which had increased in value
to $200,000. He transferred it to Daughter for $150,000 in cash in a transaction properly
identified as in part a gift and in part a sale. Suppose the transaction were viewed as a sale of ¾
of the land for full consideration and an outright gift of the other one fourth. How would this affect
Father’s gain and Daughter’s basis? Is it a more realistic view than that of the Regulations?
o § 170(e)(2) and § 1011(b)
o Issue: Bargain Sale to Charity
 Apply different set of rules for part sale/part gift
 Now changed to bargain sale to charity vs. Part sale/Part gift
o F:
 AR = 150K
 AB = 90K (allocated based on ¾ as paid in full consideration, ¼ gift)
 Gain = 60K
• and gift of 50K FMV (which goes through 170(e) for charitable
contribution deduction  Non-Miscellaneous deduction, if standard
deduction  no use
• Gus did a long policy discussion on how rich and poor contribute
differently
o Of the 180K basis to charity = 150K  Cash given (§ 1012) and 30K  ¼ gifted (1015)

35
 C. Property Acquired Between Spouses or Incidental To Divorce
• Transfers between spouses are treated as a non-taxable event.
• Transferee takes the transferor’s basis.

§ 1041 (p. 532) and Reg 1.1041-1T(a) and (d) (p. 1789)
• NO G/L is recognized – this is a non-taxable event.
o Between spouses – or between former spouses if the transfer is incident to the divorce
(occurs w/in 1 year of divorce)
• Transfer is treated as a gift → one that transferee has no income b/c of
• Transferee’s basis on a later disposition
o Pure step in the shoes
o Will always be the Transferor’s Spouses AB
 Never the FMV

Problems (p. 128)

Andrew purchased some land ten years ago for $4,000 cash. The property appreciated to $7,000 at
which time Andrew sold it to his wife Steffi for $7,000 cash, its FMV.
• (a) Tax consequences: 3K gain realized, but not recognized (§ 1041 trumps)
• (b) Steffi’s Basis: 4K -- § 1041(b) alters the “basis = cost rule”.
o What is the purpose of § 1041(b)(1)? Gift = donee’s basis depends on the BIL or BIG
o Here, § 1015 is ignored and § 1041(b)(1) automatically treats it as a gift regardless of the
Duberstein test.
• (c) Gain if sold now for FMV by Steffi: $3K gain
• (d) What if property declined in value to $3K and THEN A sold it to S for $3k?
o $1,000 Loss realized. But, what about § 267?
 §267(g) means that § 1041(a) trumps

36
 D. Property Acquired From a Decedent
• Basis of person receiving will be FMV at time of D’s death – NOT the Decedent’s AB!

§ 1014 (p. 512) – Pro-Tax Payer rule

• In general → basis of property passing to person from a decedent shall be FMV at date of
decedent’s death.
• So → if property had BIL → the loss goes away.
o Hypo → Decedents AB = $100, FMV at time of death = $70
 Person who receives → AB is $70 – step-down to FMV
o Point → it would have made more sense for decedent to have sold property w/ BIL b/c he
could have taken a deduction. Now the deduction is lost.
o BIG → if Decedent’s AB = $120, FMV at time of death = $160
 If is a inter vivos gift – donee takes donor’s AB → $120
 If inherits property → donee takes FMV → $160
• Called a stepped up basis at death
• Effect → nobody pays the taxes on the BIG (wiped out)

37
 E. Amount Realized
Amount Realized = $ received, FMV of property received, + Debt given up
• § 1001(b) (p. 511) and Reg 1.1001-1(a), 2(a)(b) and (c) (p. 1746)
• §1001(b) → Determining Amount Realized → Shall be the sum of $ received plus the FMV of the
property (other than money) received.
• Reg 1.1001-1(a) → FMV is a question of fact. Only rarely will property be considered to have no
FMV
• Reg 1.1001-2 → Discharge of Liabilities
o Inclusion in AR → the amount realized from a sale or other disposition of property
includes the amount liabilities from which the transferor is discharged as a result of the
sale or disposition.

Int’l Freighting Corp v. Comm (1943) (p. 131)

• Facts → TP is corp that adopted bonus plan for employee by paying them in stock.
o At time they bought the stock it was worth $16,153.36.
o At time of transfer to employees, FMV of stock is $24,858.75.
• TP took a deduction of the higher value in the year it gave the employees the stock
o Can deduct payment of compensation for services to employees
• IRS → said TP can only take deduction of $16K amount
o IRS had alternative argument → that TP can claim the deduction of $24K amount
but must claim a gain of $8,705.36 (difference between 16K and 24K)
• CT → agreed w/ alternative argument.
o Value of stock company gave to employees – is a income to employees for services,
therefore deductible by the company

38
 o TP has a disposition of property (the stock) which increased in value – therefore
they have a gain to claim.
o AR = FMV of stock given up – which is assumed to be equal to the FMV of the
services rendered.
• How can they have amount realized? § 1001(b) does not include “services”?
o P. 133 – “Literally, where there is a disposition of stock for services, no “property” or
“money” is received by the person who thus disposes of the stock. But, in similar
circumstances, it has been held that “money’s worth” is received and that such a receipt
comes within § 1001(b).”
• Employee’s tax liability?
o Income created under § 61(a)(1)  employee AB is 24K (FMV – Philadelphia)
o What if Employee paid with services and $10K?
 As to IF  Same AR (which is cash + property)
• Same 8K of gain, but does not have full deduction  only 14K
 Employee ahs only 14K taxable income, but basis is still 25K

Crane Deals with FMV >= NR loans

Tufts Deals with FMV < NR loans
(see discussion on DOI section on p. 40/41 below)

Crane v. Commissioner (p. 134)

• Fact → TP is widow who received property at death of her husband.
o Her basis under § 1014 is FMV at time of his death)
o FMV = amount owed on property in a non-recourse debt (this is just a coincidence)
 Debt of mort + interests = $242,052.50 → which is also FMV
 This leaves her zero equity in the property
o While she had the property → TP properly depreciated and took deductions of $28045.10
– leaving $255,997.
o TP sells property to Seller for $3K in cash plus the debt.
 Claimed a gain of only $2500
• $3K cash
• - $500 in sales expenses
• AR $2500 — AB $0 = $2500 gain
 TP → says her basis is equal to her equity, which is zero b/c FMV of property
equals the mortgage and interest owed
• At time of law – she only had to claim half – so TP said her gain was
$1250
• IRS → disagrees
o Says TP’s AB in property is
 Basis $242,052.50 — Depreciation of $28,045.10 = AB $233,997.40
o Argues her AR = $257,500 – her debt given up + $2500 in cash
 AR $257,500 — AB $233,997.40 = $28,502.60 gain.
o Said TP took depreciation value on property but wants to claim no equity in
• Crt → Agreed w/ IRS
o Said → TP got benefited from the payoff of the mortgage – just as if the $ was paid to her
and she then paid the creditors.
 If TP had gotten her way – would be double dipping
o Under § 1012 – all TP’s debt goes into her AB
 Therefore – full amount of debt given up must part of AR
o Say TP has property w/ equity in it.
 If TP has a non-recourse debt and FMV is less than debt
• TP can walk away if house foreclosed – Creditors will eat loss
 If TP has same non-recourse debt and FMV is greater than the debt

39
 • TP will NOT walk away – can sell the house and pay off debt and pocket
the equity.
• Rules
o If you include Debt amount (the mortgage) in your AB –
 You must include the same amount in your AR if you give up the debt in a
sale.
o AR → includes case received + Debt given up
 Therefore → FMV should equal cash + Debt given up
o Proper basis of property acquired from a decedent – is FMV of property at time of
his death, undiminished by mortgages → See § 1014.
 Why? → one section Code cannot be construed to defeat the intention of another
section
o Depreciation deduction → is taken on the full AB.
 Be too hard to have a floating basis – changing each month once principle
payment is reduced.
o Famous footnote 37 (p. 141) – now answered by Tuft below
o A TP who sells property encumbered by a nonrecourse mortgage must include the
unpaid balance of the mortgage in the computation of the amount realized on the
sale.
• Hypo → TP gives A property as gift – property is subject to mortgage
o FMV = $250K Debt = $200,000 AB of donor = $220,000
 Pure gift? → NO – A takes subject to mortgage.
o Is part gift/part sale situation
 Gift is = $50K Sale = $200,000 b/c FMV = $250,000

Comm v. Tufts (p. 143)

• Issue → What if FMV is less than the non-recourse debt owed?
o Crane → did not answer this question! (Footnote 37
• Facts → TP is a P/S formed to build apartment building
o Gets loan → $1,851,500
o Down Payment → $ 44,212
o AB $1,895,712
o Depreciation → $ 439,972
o AB → $1,455,740
o Bales bought → subject to mortgage. FMV at time of sale was $1,400,000
• TP argues →
o AR 1,400,000 (FMV) — AB 1,455,740 = $55,740 Loss
• IRS argues →
o AR 1,851,500 (debt given up) — AB 1,455,740 = $395,760 Gain
• Rule → Crt → Agrees w/ IRS – TP must put all debt given up into AR
o Is it NOT limited to the FMV.
• TP → had argued that b/c they could not sell for more than FMV of $1.4 mil – that should be AR
o Crt → said no. TP is getting rid of mtg debt – must be included into income
o Plus → they put in total of $44,212 and were able to depreciate over $400K and now
want to claim a loss of $55K???? Come on!
• Point → Relevance of FMV at time of disposition → is irrelevant
o AR = Cash, FMV of property, and full debt given.
• Reg 1.1001-2(a)(2) → Recourse Loan
o Amount realized on a sale or other disposition of property that secures a recourse liability
does not include amounts that are income from discharge of indebtedness under § 61(a)
(12)
 So → If TP keeps recourse loan → will NOT include the amount in the AR
 If Seller assumes the Recourse Loan – must go through the following steps:

40
 o O’Connor applied recourse rules to the facts of the case –
 If loan is recourse loan – must bi-furcate between loan transfer and
property transfer.

 Property Loan

AR $1.4 mil (FMV) AR $1,851,500 (debt going away)

— AB $1.455,750 — AB $1.4 mil (FMV)
$55,470 Loss $451,400 → Discharge of Indebtedness to
Seller

395,760 Gain to TP

o Although result is the same as the non-recourse loan

 The tax consequences will be different.
o Why did Seller buy this property getting a loan for more than FMV?
 Gus → either he never planned to pay off loan or maybe interest rates had an
effect.
 Gus likes the O’Conner concurrence

Problems (p. 50)

(1) M purchased a parcel of land from S for $100,000. M borrows $80,000 from Bank and pays that
amount and an additional $20,000 of cash to S giving B a nonrecourse mortgage on the land. The land is
the security for the mortgage which bears an adequate interest rate.

• (a) What is M’s cost basis in the land?

o $100,000
o Loan is not income b/c of presumption that you will pay back (off-set by liability)
• (b) 2 years later when the land has appreciated in value to $300K and M has paid only interest
on the 80K mortgage, M takes out a second nonrecourse mortgage of $100,000 with adequate
rates of interest from Bank again using the land as security. Does M have income when she
borrows the $100,000?
o No income. M’s equity = $220K
o Borrowing money does not create income unless the borrower never expected to pay it
back.
• (c) What is M’s basis in the land if the $100,000 of mortgage proceeds are used to improve the
land?
o $200K (Basis + improvements)
o Basis goes up  § 1016(2)(a)
o Capital expenditure (properly allocable to capital account)
• (d) What is M’s basis in the land if the $100K of mortgage proceeds are used to purchase stocks
and bonds worth $100?
o 100K basis in the land
o M has 100K basis in stocks and bonds (is all debt) – Cannot increase basis in land b/c it
did not go to the land
• (e) What result under the facts of (d), above, if when the principal amount of the two mortgages
is still $180K and the land is still worth 300K, M sells the property subject to both mortgages to
Purchaser for $120,000 cash? What is P’s cost basis in the land?
o P’s basis in the land = 300K (= FMV)
o M’s tax consequence = AR 300K (180K debt given away + 120K cash) – AB 100K =
200K gain
• (f) What result under the facts of (d), if instead M gives the land subject to the mortgages and
still worth $300,000 to her son? What is the Son’s basis in the land?
o Part sale/part gift:
 M’s tax consequences § 1.1001-1(e);

41
  S’s tax consequences = 1.1015-4
 Duberstein Test
o M’s tax consequence = AR 180K – AB 100K = 80K gain
o S’s basis = 180K *use greater of what he paid v. M’s basis
 Here he took subject to the loan of 180K
o Why this is the way? FMV went from $100K to $300K  this $200K gain must be
accounted for somewhere
 M has $80 gain
 If Son sold for FMV  $300K – AB $180K = $120K + M’s $80K = $200K
• (g) What results under the facts of (f), above, if M gives the land to her spouse rather than to her
son? What is Spouse’s basis in the land? What is Spouse’s basis in the land after Spouse pays
off the $180,000 of mortgages?
o This is § 1041
o Transfer between spouses – no gain/loss – step in to donor’s shoes ($100K)
o When loan paid off  no effect on basis
• (h) What results to Mortgagor under the facts of (d) above if the land declines in value from
$300,00 to $180,000 and Mortgagor transfers the land by means of a quitclaim deed to Bank?
o THIS IS THE CRANE CASE
o 100K of proceeds went to house – other $100K went ot stocks
 AR 180K ($200K loan - $20K cash  is debt given up)
 AB 100K (total $ in house  other $100K went to stocks and did NOT affect the
basis of the house
 $80K gain to M
• (i) What results to M under the facts of (h), above, if the land declines in value from $300,00 to
$170,000 at the time of the quitclaim deed?
o Does not matter → answer is same b/c AR and AB are the same
o What if was a recourse loan?
 Would need to split in 2
 Property Transfer Loan Transfer
AR = 170K (FMV) AR = 180K (debt)
AB = 170K AB = 170K (FMV used to satisfy debt)
70K gain 10K gain
Same 80K above
o Different character for nonrecourse loan  this probably gives “long-term capital
gain treatment” which is a lower rate

(2) Investor purchased three acres of land, each acre worth $100,000 for $300,000. Investor sold one of
the acres in year one for $140,000 and a second in year two for $160,000. The total amount realized by
Investor was $300,000 which is not in excess of her total purchase price. Does investor have any gain or
loss on the sales?
• Point: allocate basis among parcels of land
o Cannot delay tax, allocate AB among separate parcels based on worth
o Allocate bases at time of purchase

(3) Gainer acquired an apartment in a condominium complex by inter vivos gift from Relative. Both used
it only as a residence. It had been purchased by R for $200,000 cash and was given to Gainer when it
was worth $300,000. R paid a $60,000 gift tax on the transfer. G later sells the apartment to Shelter.
• (a) What gain or loss to Gainer on his sale to S for $300,000?
o § 1015(d)(6)  Increased basis for gift tax paid.

42
 • Increase in basis with respect to any gift for the gift tax paid shall be the amount
which bears the same ration to the amount of tax so paid as:
• The net appreciation in value of the gift, bears to the amount of the gift

X (increase to basis) = Net Appreciation ($100K) (FMV — AB)

Amt of tax paid Gift (FMV)

($60K) ($300K)

o X = (FMV – AB)/FMV X (Gift Tax)

o X = 20K  200K + 20K = $220K
• G’s Basis = $220K (AR $320K — AB 220K = $100K gain )
o The theory is that it is going to be taxed when donee sells,
so this is to avoid a double tax

Effect on Realization of Tax Principle - Rule: Don’t take into income until a Realization Event

Appreciable Pays Annual Return

(no current return (not interest))
10K In initial Investment 10K
10% YR 1 Return on reinvestment 10%
------ ------
$1K Return 1,000
O Yr. 1 Tax (40% tax rate) (400)
------ ------
11K REINVEST 10,600
10% Yr. 2, ROR 10%
------ ------
1,100 Return 1060
0 Yr. 2 Tax (40%) (424)
12,100 REINVEST 11,236
------ ------
10% Yr. 3 ROR 10%
1,210 Yr. 3 Return 1,124
SALE
AR = 13,310
AB = 10,000
G = 3,310
40% tax (may be lower b/c of capital gains)
1324 (all in year 3 (450)
------ ------
$11,986 After Taxes $11,910

• $76 Dollar difference. Why? DEFERAL putting off of paying taxes (Time Value of Money)

8. Life Insurance and Annuities (Chapter 7)

A. Life Insurance
§ 101 – Certain Death Benefits (p. 77)
• 101(a) Proceeds of life insurance contracts payable by reason of death
o GI does not include $ paid under life insurance K if such amounts are paid by
reason of the death of the insured.
o 2 types of life insurance

43
  Term – pay premium for period of time. When time is up and if you are not dead
– you loose out on money
• Has no cash value
 Whole Life → investment. Builds net asset value – can borrow against and cash
in policy and get net asset value.
• AB = includes entire amount of premium paid.
o So → life insurance is tax free if paid out by reason of death
 If TP has whole life insurance and cases it out early
• Proceeds are taken into income
• 101(g)(1) Cash out
o It TP is terminally ill or chronically ill → can cash out and proceed NOT taken into income
• 101(g)(2) Viatical Settlements
o Normally under §101(a) → need death 1st to be tax free
o If person is ill and needs $ - he can sell the Life Insurance policy and proceeds he gets
are not taxed.
• Policy:
o Beneficiaries have suffered enough (the proceeds are to help the insured’s beneficiaries).
However, the counter-argument would be that the insured should just get a bigger policy.
This would act as a subsidy to the insurance industry b/c people would have to buy larger
policies (and pay higher premiums).

Problems (p. 155)

(1) 1Insured died in the current year owning a policy of insurance that would pay Beneficiary $100,000 but
under which several alternatives were available to Beneficiary.

• (a) What result if Beneficiary simply accepts the $100,000 in cash?

o $100K not included in gross income--§ 101(a)(1) (p. 77)

• (b) What result in (a) above, if Beneficiary instead leaves all the proceeds with the company and
they pay her $10,000 interest in the current year?
o $10K is included in income--§101(c) (p 77)
o § 1.101-3 – no diminution of the principal of the proceeds so interest on life insurance
proceeds retained by the company is taken into income.

• (c) What result if Insured’s Daughter is Beneficiary of the policy and, in accordance with an option
that she elects, the company pays her $12,000 in the current year? Assume that such payments
will be made annually for her life and that she has a 25-year life expectancy.
o Amount excluded = amount payable at death / life expectancy
o § 101(d)(1) and 101(c)
o $8,000 is taken into income and $4,000 is excluded

• (d) What result in (c) above, if Insured’s Daughter lives beyond her 25 year life expectancy and
receives $12,000 in her 26th year?
o The 26th year she reports $8,000 as income and $4,000 is excluded
o §1.101-4(c)

• What if B lives beyond 25 years?

o Year 26 → Same amount is Excluded!!!!! → $4K and $8K is income
 If you elect to received $ over your life expectancy
 $ is prorated the same every year no matter what!!!!!
• Compare to Annuity → where if she had one for 25 years – in year
26 → the whole thing would be income
• What if B dies before 25 years?
o She CANNOT deduct for amount of the un-recovered proceeds!!!!!

44
 o If she died in Year 3 – all that money is a lost
 Compare to annuity → which would have allowed a deduction
• Point → There can be good and bad things from § 101 when TP agrees to accept life insurance
benefits over span of life
o If live longer than life – can receive more than amount of benefits w/out being taxed on
 Why? Hard to start taxing the elderly
o If live shorter → cannot deduct $ from last tax return. $ is gone.

• Insured buys single premium $100K insurance policy for $40K.

o I sells policy to her child for its $60K FMV and on I’s death, $100K goes to child
 I → is taxed on the $20K gain from the sale
 Child → gets $100K tax free

o I sells policy to her spouse for $60K

 Spouse to Spouse transfers → no gain/loss. I → has no gain to report
 Spouse → gets $100K tax free

o I is certified by physician as terminally ill and sells policy for its $80K FMV to Viatical
Settlements, who collect the $100K on her death
 § 101(g) → Neither are taxed
 I needs to meet definition of terminally ill

B. Annuities
§ 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts (p. 61)
• § 72(b)(1) Exclusion ratio X Annual Payment = Amount Excluded
• TP pays $ lump some to company (you are lender and debtor)  Assurance company
• They in turn agree to pay you X amount of $ for the rest of your life.

45
 o GI → does NOT include any part of the amount which bears the ratio to your investment
 People are NOT taxed on a return of capital.
 Need to prorate the amount to find out what part of payment is GI
 § 1.72-5 (p. 1045)
• X = Investment in K x Full annuity payment due / year
Expected return
Expected return = Total year of payments x payment per year
Investment in K = basis

• If you die early → (Insurance companies win)

o Any amount of your original investment left → can be deducted from your last
income tax
• If you live past date of life expectancy
o Full amount of payment is taxed

Problems (p. 160)

(1) In the current year, T purchases a single life annuity with no refund feature for $48K. Under the K T is
to receive $3K per year for life. T has a 24-year life expectancy.
• (a) To what extent, if at all, is T taxable on the $3000 received in the first year?
o The expected return is $72,000
 $48,000 / $72,000 X (Annuity payment = $3,000)
 1/3 X $3000 = $1,000 (WHICH IS INCLUDED
o $2,000 is excluded, $1,000 is included
o If under 101(d) (life insurance), would be the same answer
• (b) If the law remains the same and T is still alive, how will T be taxed on the $3K received in the
30th year of the annuity payments?
o § 72(b)(2) – ALL is income
o If this were under § 101(d) – Only $1,000 is included
• (c) If T dies after nine years of payments will T or T’s estate be allowed an income tax deduction?
How much?
o $2,000 x 8 remaining years = $18,000 (amount of payment recovered)
o $30,000 = unrecovered investment in K (§ 72(b)(3)  Loss on last income tax return
o Under 101(d), $30,000 is lost

9. Discharge of Indebtedness (Chapter 8)

A. Discharge of Indebtedness

46
 • DOI = COD (Canceling Of Debt)

§ 61(a)(12) → Discharge of Indebtedness is income

• Loan proceeds → NOT income b/c TP has offsetting obligation to repay
• If he got the loan and did not pay back later → TP would have income

§ 108: Income from Discharge of Indebtedness and Bankruptcy (p. 84)

• 108(a): GI does not include the following
o (the recognition of the obligation to repay is washed)
o 1. DOI in bankruptcy
 All DOI is excluded
o 2. DOI occurs when TP is insolvent (the FMV of TP’s assets are less then all his
liabilities) §§ 108(a)(3) (rule), 180(d)(3) (definition)
 Amount excluded – is limited to amount of insolvency
• DOI = $100K
• TP’s liabilities = $200K and FMV of assets = $120K
o TP can exclude $80K (§ 108(a)) – ONLY THIS WOULD GO
TO § 108(b), not the full $100 DOI
 Takes $20K into income (§ 61(a)(12))
o If this was bankruptcy → All $100K would be excluded
 Here, take full $100 to § 108(b)
o So → if TP’s DOI does not fit into either of these → TP has income

• 108(b) → To extend that exclusion of DOI is allowed under 108(a) → there shall be a
corresponding reduction in the following tax benefits in the following order:
o 1st → NOL → Any net operating loss for the taxable year of the discharge, and nay net
operating loss carryover to such taxable year
 $1 for every $1 of DOI
 You cannot get a negative income refund here, but taxes in other years will be
less.
o 2nd → General Business Credit → any carryover to or from the taxable year of a
discharge
 33 ⅓ cents for every $1 of DOI
o 3rd → Minimum Tax Credit
 33 ⅓ cents for every $1 of DOI
o 4th → Capital loss carryovers
 $1 for every $1 of DOI
th
o 5 → Basis reduction  § 1017 (may not even have to reduce)
 $1 for every $1 of DOI
o 6th → Passive Activity and credit carryover
 $1 for every $1 of DOI
o 7th → Foreign Tax credit carryover
• 108(b) → amount excluded under 108(a) – is taken into 108(b)(2) to reduce tax attributes. Must
go in order!
o TP has $100K of DOI which is excluded under 108(a)
 $100K DOI
 - $ 30K NOL → DOI reduces $ for $
 $ 70 K DOI left and TP has $0 left for NOL to take

o Next → would reduce GBC by the rest of the $70K DOI left
o Suppose there is still $70K DOI left by the time you got to 4th spot →
 $70K DOI
 - $50K Capital Loss Carryover → DOI reduces $ for $
 $20K DOI left and TP has $0 left for Capital loss carryover

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 o Next in line is Basis Reduction
 $20K DOI
 - $80K Basis in reduction → DOI reduces $ for $
 $60K TP gets to take the $60K in reduction. DOI has been reduced to
$0

• § 172 – (NOL) Net operating loss (p. 187)

o TP hates to loose this!
o Allows a biz to spread 1 years loss to other years w/ profit
 If TP’s company had deductions exceeding profits –
 Can carry this NOL back up to 2 years and amend tax form to get tax refund.
• Reduces tax income in the following 20 years (if still some left)
o § 172(c) – Defines – NOL = the excess of the deductions allowed by this chapter over the
GI. Such excess shall be computed with modifications specified in subsection (d)
o § 172(d) – Modifications (not covered, we will be told the NOL on the exam)
o § 172(b)(1)(A) – We will cover – What do you do with a NOL?
o § 172(b)(3) – Election of NOL for carryback or carryover:
 If elected not to carryback, it has the benefit of not having to file amended return,
but the disadvantage of waiting.
o Back to back NOL are handled on a back-to-back basis

• GBC and Min Tax Credit

o Naturally, you prefer a $1 credit over a $ deduction. That’s why they only give you a % of
the credit.
o Reduces these by 33 ⅓ cents for every $1 of DOI
 So → Reduce $1 of Credit for every $3 of DOI.
• $100,000 of DOI
• - $30,000 of GBC → Multiply $30K x 3 = $90K
• $10K of DOI left (note, that 70K is not left, but 10K!!!)

• 108(b)(5) → Election → may be good in some cases

o Allows TP to elect to depreciate property 1st → before going down rest of list under
108(b)(2) above. Protects everything else in line.
 Moving Basis reduction to top – helps to protect TP’s NOL
 Gives benefit right now – by giving up basis TP has the better deal – time value
of $
o If NOL is $30K w/ $100K of DOI to deal w/
 If there is $180K of basis to reduce
 Can move this to top of list – wipes out all DOI
• TP gets to keep all NOL!
o Even if basis is only $80K
 Will end up taking NOL → But protects everything else on list.
o Big picture → is time value of money – Can use NOL and CLC now to make money off of
them.

• § 1017 → Discharge of Indebtedness (p. 516)

o (a) Generally, if an amount is excluded from GI under 108(a) and under 108(b)(2)(E), (b)
(5), or (c)(1) → any portion of such amount is to be applied to reduce basis
 Then such portion shall be applied in reduction of the basis of any property held
by the TP at the beginning of the taxable year following the taxable year in which
the DOI occurs
o This was passed in 1980 to help uniformity between tax and bankruptcy law (which has
the goal of giving bankrupt person a fresh start)

48
Case recap:
• In Eisner v. Macomber → the CT had said a stock dividend was not included into GI. They held
GI was gain derived from capital or labor or both – provided it includes a severance. b/c a stock
dividend is not a severance – it was not a taxable event
• In Kirby Lumber → bonds were issued. Later buys them back after price went down. They
issued them $500 but bought them for less – say $400 - $100 difference. Kirby Lumber → said
no severance so not taxable. CT → said no – was a taxable event b/c Kirby was better off.
• In Helvering → LL leased land to T – who built a house. T forfeited from non-payment on
mortgage and left….leaving LL the land and the house (which was more $ than the land). IRS
says LL has income in the amount of the house. CT → agreed. Said no severance necessary.
 Not → LL had problem b/c no $ to pay taxes. Code made change – LL does not
realize the income till he sells the land. Income at the sale – not at the forfeit.
• Then, Glenshaw Glass

Kirby Lumber Co. (p.162) → Freeing of assets theory (Freeing from Creditor’s Claims)
• Facts → Kirby issued own bonds for $12,126,800. Later it purchased some back for a lesser
price than what they were issued for = $137,521.30 difference.
o Issue → is the $137K income to Kirby?
o Bonds were recourse (general debt obligation of company to bond owner; rights to
general assets of the Company)
• CT → Says yes
o TP made a clear gain. It no longer had to pay the full amount of the bond – something
they would have been required to do
• If a TP pays off a debt for less than the amount he owed
o The difference constitutes income to him b/c he realized an economic benefit by
way of an increase in his net worth must as if he sold the property at a profit.
 Taxable event → is the freeing of assets that were previously held subject
to the obligation.
• Say → Kirby issued bonds worth $100,000 → this creates a debt for them of $100K
o Then Kirby buys bonds back for $80K
o They are $20K better off – has this much in free assets now and this is income to them.
• Part payment on bond (not zero coupon bonds (original issue discount))
o What Changed:
 (1) Interest rate goes up (inverse relationship)
• Look to the interest rate (current market rate)
• Time of maturity of bond (Shorter/better)
o Discount amount increases:
 (1) Distance between interest rates
 (2) Length of time to maturity
• Interest rates go down, bond premium could rise
 (2) Debt rating goes down (risky company A,AA,AAA)
• Company would have to issues now bonds with higher interest
• Non recourse liability (Freeing of Asset Theory)
o If your corp has:
 Assets = 10K in cash; 7K in property
 Liabilities = 9K in NR loan
 Equity = 8
o If you give away the property:
 Assets = 10K in cash
 Equity = 10K (gain of 2K!!)
o Getting rid of property = no assets freed
o FOA = always works for recourse; not always for NR (as long as NR> FMV of only
property securing)

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 • Crane: (FMV > NR)
o Economic Benefit Theory: Owner going to treat just as if it were a R loan b/c property
(b/c property has equity). Owner would never walk away (you’d rather sell and pocket
equity after paying of the debt (i.e., freeing of asset works).
• Tufts: (FMV < NR)
o Economic Benefit Theory does not work (there is no freeing of assets).
o Would be cheaper to walk away from the property

Problems (p. 177) – assume no insolvency

• 1. P borrows $10K from R years ago. What tax consequences to P if he pays off the so far
undiminished debt w/ (note that R is covered under § 166 – Bad debts, not on exam)
o (a) $7000 cash settlement → P has $3000 in income
o (b) A painting w/ basis and FMV of $8K? P has $2000 in income
 DOI of $2000
 Under § 1001(a), disposition, but here there is no difference between AR/AB
 International Freighting Situation – only difference is that employee gave services
 If loss, a corp takes under § 165(c)(1) and an active investor under § 165(c)(2)
o (c) Painting w/ basis of $5K and FMV of $8K P has $5000 in income
 Characterized as $2K DOI – Ordinary gain
 Characterized as $3K gain (Capital Gain…maybe ST or LT)
 Rich’s basis = 8K
o (d) Services to R worth $10K? P has $0 income
 Focus on the DOI. Not a return of capital, b/c you have to think of it in two
separate transactions:
• Creditor – Debtor
• Service purchaser – IC
• See § 212 – Expenses for the production of income
o (e) Services to R worth $8K? P has $2000 in income
o (f) P’s employer pays R $7K P has $10,000 in income
 (he does not have to pay back)
 Think of it in terms of the Tax Triangle (with three parties) like Old Colony Trust
 R = Bad debt 3k Loss
 P = 7K Compensation for services; 3K DOI
 What if Employer instead gave land of 4K AB and 7K FMV?
• P: nothing changes; R: nothing changes; E – Business deduction? 3K
gain on disposition of land

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 10. Damages and Related Receipts (Chapter 9)
A. In General – Business Context
Raytheon Production v. Comm (p. 180) – TP received damages (1/3 compensatory and 2/3 punitive) in
an antitrust settlement – this is not under § 104(a)(2) b/c not personal injuries
• The business was completely destroyed. To determine the value, they used lost profits brought
to present valu terms. Case would have been very different if business survived.
• So, this treated as recovery of capital. Like asset being destroyed (with is under “other
disposition”). Here, Damages = AR, we now need to figure out the AB to figure G(L)
o If just lost profits, would have been viewed as income simply.
• Issue → should TP include the damages in GI?
• CT said, In business situation, the question to ask:
o In lieu of what was the settlement amount paid?
o If damages are in lieu of lost profits → are Income.
 b/c if they would have earned the profits it would have been income
 there is NO disposition of property
o If damages are in lieu of capital loss (like destruction of biz or injury to good will)
→ Not income.
 Unless damages exceed TP’s basis in property → excess IS taxable.
 Why? → if biz destroyed – is a disposition of property and return of capital asset.
• So damages are AR. When subtract TP’s AB = Income
• Here → the suit was NOT for recovery of loss profits
o TP’s biz was totally destroyed and did not exist anymore.
o TP’s recovered damages are for capital loss
 Any amount over TP’s basis in biz/good will is taxable.
• What is TP’s income?
o Crt said Compensation for the loss of TP’s good will in excess of its cost is GI
 TP can recover basis in property – but must pay tax on balance of damage
award above
o Damages: AR $3 million (b/c is a disposition of property)
o — AB in property
Amount left over is taxed
• How are damages determined? →
o Same for loss profits and destruction of biz.
o To determine loss profits → look at future income. Stream of loss profits -
discount back to present value.
 Value of an asset = present value of the future stream of income it will
produce

Goodwill – business name, recognizability (going concern value)

• If A was to buy B’s biz – money paid is for more than just physical assets
o Are also paying for good will
• To have basis in Good Will → biz must have been obtained by purchase
o A new biz – has no basis in good will – it is built over time and has a basis only when
the Buyer is paying something for it as part of the purchase price.
o So → only when Buyer buys good will – is there a basis in good will.
o Seller does not have basis in goodwill.

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 • Damages for injury to good will – represent a return of capital and w/ certain limits are not taxable
→ unless damages received exceed basis in good will.

Distinction in case to be made.

• If Biz were to continue → no disposition of any property.
o And all damages would have been for loss profits and included into income
• If Biz were to be destroyed → there is a disposition of property (all assets are gone)
o Damages are for a return of capital
o Treat damages as AR for disposition of assets – subtract whatever AB TP had in
property and get TP’s gain or loss
 AR → X$ in damages
 — AB → what TP’s basis in biz is – determined by anticipated earnings.
Capital L/G
 Note → Capital L/G → is taxed at lower rate!!
o Gus → says to calculate damages for both the same way
 Look at anticipated earnings – Need to look at future amount of profits to
establish value of the good will and biz.
o Gus is critical of the destruction of assets vs. lost profit distinction
 Big question is how to determine value of business (not what the willing buyer
would pay)
 Value is present value (discounted back to present value) of future string of
income
 But, maybe treated as capital gain, so won’t be taxed as high as your income

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 B. Damages for Personal Injuries
§ 104(a) → Compensation damages for injuries or sickness (p. 81)

§105 → Amounts received under accident and health plans

• 105(a) → Amounts attributable to Employer contributions

• 105(b) → Amounts expended for Medical Care
• 105(c) → Payment unrelated to absence from work
• 105(e)→ Accident and Health plans

§106(a) → Contributions by employer to accident and health plans

• GI of an employee does NOT include $ employer spent providing coverage for accident/health
plans.

Personal Injuries

• Excluded from income.

o Any $ paid compensation of work related personal injury/death under worker’s
comp
 If TP receives benefits for injuries not related to work – they are included in GI
o Compensatory Damages incurred on account of personal physical
injuries/sickness → § 104(a)(2)
 Exclusion → applies to damages from tort claims.
 Damages for loss wages → NOT included into GI if they are compensatory
damages (§ 104(a)(2) says “any”)
 $ received to settle lawsuit are excluded to extent nature of claim was for
personal injury
 BUT →
• Exclusion → does NOT apply to any amounts TP deducted for
medical expenses under § 213.
• Don’t want TP to double dip → cannot take a §213 deduction the year
medical expenses are paid and then excluding $ received for
compensation of the medical expenses under § 104(a)(2)

o Emotional Distress →
 Which flows from the physical injury → all excluded
 Payment for medical cost of emotional distress → all excluded

o GI of an employee does NOT include $ employer spent providing coverage for

accident/health plans → §106(a)
 Amounts paid by employers for insurance premiums or $ paid to accident plan

o Amounts received under accident and health insurance policies for personal
injuries/illness → § 104a3

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 o Disability pensions of members of armed forces

• Included in income.
o Damages for nonphysical personal injuries
 Defamation, sex and age discrimination, 1st Am rights
o Punitive Damages (all are included)
 Recovered in physical personal injury suit
o Emotional Distress damages not incurred on account of physical injury.
 Except → to extent damages received are for amounts paid for medical care
attributable to the emotional distress are excluded
• Example → TP gets $10K damages for emotional distress. Spent $3K
for treatment for ED. Only $7K of damages are income.

• Example → TP in car accident w/ physical and emotional injuries. Receives the following
o $150K → Compensatory Damages (medical care, lost wages)
o $75K → punitive damages
o $100K → emotional distress
o $30K → cost for ED treatment
 What is income? → $75K punitive only
 Compensatory damages – not income under §104a2
 Emotional distress → b/c underlying injury/illness is a physical one – all excluded
 ED treatment → is always excluded

• Both 104 and 105 → does not allow for exclusion of any money from income - $ deducted by TP
under § 213 in any prior year.
o If TP deducted medical expenses under § 213 and insurance company reimbursed
TP for medical expenses – all the reimbursement is income to TP

• 105(b) v. 104(a)(3)
o 105(b) Excess $ received → is included into income
o 104(a)(3) Excess $ received → is excluded from GI

Medical Insurance

• Employer-Employee Situations

o 106(a) → any $ paid by employer for accident/health plan

 NOT included into employee’s GI
 No dollar limits – want employers to provide insurance to employees

o 105(a) → amounts received by employee from insurance for personal

injuries/sickness
 ARE included in GI → BUT see 105(b)

o 105(b) → Amounts TP/employee is directly or indirectly reimbursed from insurance

Employer pays for is excluded.
 Limited to amount TP paid for health care.
• So → whatever TP gets back from insurance company for
reimbursement of medical expenses are not included into income.
 any amount that exceeds what medical costs TP incurred → is income to
TP

• Health Insurance maintained by TP individually

54
 o 104(a)(3) → ALL amounts received under accident/health insurance policies or
through self insurance arrangement – for personal injuries/illness
 Are excluded from GI → even if they exceed medical costs.

• Problem
o TP has 2 insurance policies
 1 provided by employer
 1 TP bought for himself
o TP has injury → sustains $4000 in medical costs.
 Insurance companies → reimburse TP total of $5000
• Received $3000 under TP’s own policy
o Under § 104a3 → All $3K is excluded from income
• Received $2000 under Employer’s policy
o How much income does TP have from the $2K?
 Need to prorate the $4000 between the 2 policies
• Employer § 105b → 2/5th X $4000 = 1600
• Self § 104a3 → 3/5th X $4000 = 2400
 Income = 2000-1600 = $400 in GI

United States v. Murphy (Handout)

Facts:
• Murphy brought suit following the denial by IRS of her claim for refund of taxes on compensatory
damages she was awarded in action against her former employer under whistle blower
environmental statues. Two arguments:
o Excluded as personal injury under 104(a)(2) – NOT EXCLUDED
o Unconstitutional b/c 104(a)(2) fails to exclude from GI revenue that is not income under
the 16th amendment – UNCONSTITUTIONAL
• Awarded 45K for emotional distress; 25K for injury to reputation; NONE of the award was for lost
wages or diminished earning capacity (paid $20,665 taxes)
• Filed return; then filed amended return w/ dental records; IRS denied
• Found Murphy had standing; but rejected both arguments

Legal Issue: Whether damages received for mental distress and loss of reputation are properly taxable
when they were not received “in lieu of” something normally taxed as income nor were they within the
meaning of the term “incomes” as used in the 16th amendment?

Holding: UNCONSTITUTIONAL Damages received for nonphysical injury is not to be included within
gross income of the taxpayer when it is unrelated to lost wages or earnings.

• P. 84 – O’Gilue  “on account of” means “strong causal connection” – rejected “but-for” test
• Drafting comment: be careful how you label injuries in complaint. Tortfeasor may not care.
• 16th Amendment:
o CNG can tax income  GI (§ 61(a))
o CNG going far as it can tax wise
• Murphy’s argument  Restoration of capital
o Not income, but, by analogy  Human capital.
o CT found this not to be persuasive (see FN, p. *8)
• Looked at Three Sources:
• Gus finds this to be an result oriented decision, relying on old authorities
o He “underwhelmingly” agrees. Although, he is focusing on gain vs. income
• (1) Attorney General: take the place of capital
o When you talk about capital, aren’t you just saying “basis”?

55
 o Raytheon  income vs. gain
o What basis do you have in your human capital? Money spent on your education? Can’t
you then get business deduction? No, but this would be a good argument.
o They don’t want to tax it b/c it is too hard…so, applied 16th Amendment here as an out.
• (2) Revenue Ruling
o Are they saying it is income, just not taxable? What’s the basis of exclusion?
• (3) House Report
o Doubtful it is gross income.
• Murphy contends that predecessor of § 104(a)(2) has meaning of framers:
o Saying income does include this? Why have this §? To excluded from GI
• P. *7, § 213(b)(6) – not limited to physical.
o § 104(a)(2) – personal physical excluded

11. Separation and Divorce (Chapter 10)

A. Alimony and Separate Maintenance Payments
• 3 types of payments (rules try to prevent people hiding (2) and (3) as (1))
o (1) § 71(a) – Alimony/SM Payments
 Income to payee
 Above the line deductible to payor under § 215
o (2) § 1041 – Property Settlements
 If payment does not meat definition of child support or alimony – is property
settlement
 No G/L
 Basis → Step in shoes of ex-spouse
o (3) § 71(c) – Child Support
 Not income to payee nor deductible for payor
o Rehabilitative alimony more common (limited time; recipient spouse gets training and
goes into workforce

§ 71 → GI → includes all amounts received as Alimony and Separate Maintenance Payments.

• Applies to payments made pursuant to a divorce or separation instrument.
• Alimony/SM payments means any payments in cash if (§ 71(b)(1))
o (A) Payment received by spouse under a divorce/separation instrument
 § 71(b)(2):
• (A) A divorce decree (divorce) or separate maintenance (i.e., religious
“divorce”) or a written instrument incident to such a decree
• (B) a written separation agreement, or (separation)
• (C) a decree (not described in subparagraph (A)) requiring a spouse to
make payments for the support or maintenance of the other spouse
o Temporary maintenance prior to final decree
o (B) Instrument does not designate the payment as a non-alimony payment (does
not designate payment as non-includable into income and not allowable as a
deduction under § 215)
 § 71(b)(1)(B)  Opt out by saying “not alimony”
o (C) Parties are not members of same household at time the payment is made (in
cases of legal separation and divorce)
 Only applies to § 71(b)(2)(A), not (B) or (C)
 Encourages avoiding divorce by tax benefits
 Now without the old marriage penalty, this isn’t a big deal

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 o (D) There is no liability to make any payment in cash/property after death of payee
spouse and
 Otherwise, looks like property settlement (or maybe child support)
o (E) The payment is NOT for child support.
• Must meet all 5 of these or is not alimony
• If death during taxable year, file as joint this year and next

• § 215 → TP can deduct an amount equal to the alimony/SM payments paid.

o Is an above the line deduction → lowers AGI

In order for paying ex-spouse TP to deduct under § 215 → receiving ex-spouse must be including
payment into income under § 71. If they file jointly → § 71 and § 125 does NOT apply

Instrument → §§ 71 and 215 apply in 4 situations

• 1. divorced
• 2. legally separated
o #1 and #2 → Cannot be living together
• 3. Married but payments are directed by a written separation agreement
• 4. Married but payment are directed under a support decree.
o #3 and #4 → may live together

• If designated as non-alimony payments

o Helps receiving TP → no need to add to income
o Hurts payor TP → cannot deduct from income.

• Not designated as nondeductible/nonicludable

o If cash payments are designated as non-alimony in divorce/separation instrument
 They are NOT alimony – but property settlement
o Effect → allows spouses divorcing to treat what would be alimony as non-alimony
 Allows → them to split tax bill or decide who will pay the tax
 Someone must still pay taxes

• Separate households
o Ex-spouses who are divorced or legally separate may not be members of the same
household
o Non divorced and non-legally separated → may be members of same household
 Policy → to encourage reconciliation
• Cash only
o Can be paid to someone other than ex-spouse
 Like pay her landlord – still alimony
o If not in cash → not considered an Alimony/SM payment
 It is considered a property settlement

§ 1041: Transfers of property between spouses incident to divorce (p. 532)

• No G/L recognized → this is a non-taxable event
• Transferee’s Basis
o Pure step in shoes of transferor
o Transferor has transferor’s basis and transfer is treated as a gift
• Incident to divorce → Transfer must
o 1. Occur w/in 1 year after date on which marriage ceases or
o 2. Is related to the cessation of the marriage.
• But, it is wise planning to look at the AB…b/c you will sell it off later. Probably is malpractice if
divorce attorney doesn’t consider this.

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§ 71f → Alimony Recapture Provision (CB p. 197-200; IRC p. 60)
• If there is an excess of alimony payments at the beginning (cannot amended return)
o Payor spouse shall include excess payments into GI during 3rd year after payments
began.
o Payee spouse → shall be allowed a deduction in 3rd year
• Effect → stops TPs from masking a property settlement as alimony
o Which they are doing b/c they are trying to shift the tax burden
 Alimony – allows deduction/income
o TPs cannot shift tax burden in a property settlement
 There is no deduction/income under property settlements
• What’s it look like → Alimony that drops off in later years looks like a property settlement paid up
front as alimony
• Requires → a transfer of CASH → or else it is not alimony
• Exceptions
o Does not apply if payments ceases by reason of death/remarriage before 3 post
separation year
• The reason it stops on the third year is b/c payee spouse probably won’t agree to it (too risky to
leave the lump with payor spouse…what if he blows it?)

If on test – look at Betty’s outline pg 92

§ 71(c) → Child Support Payments → Are not included in payee’s GI nor deductible to payor.
• Should be specifically stated in divorce agreements
o How much of the payment is for child support.
• If instrument does not list payment as Child Support
o BUT → allows for reduction in payment to payee spouse related to contingency involving
the child (attaining a specified age, marrying, dying, leaving school)
 The amount of the reduction will be considered child support.
o Example → divorce/separation instrument requires payor spouse to pay payee spouse
$12000 for life.
 If payment drops to $8000 after minor child reaches 18
 $4000 is considered child support.
• Not responsible for § 71(c)(2)(B) for exam

• See also Reg 1.71-1(T)(c), Question 18 (pg. 1042)

Personal and Dependency Exemptions → § 151-152

• All TP’s have one automatic deductions for themselves/spouse and for their dependent children
in addition to the Standard or Itemized Deductions
o Who gets personal exemption? → §152(e)(1) → Custodial parent
o Parent child lives w/ gets the exemption → not the parent paying the support.
 But → custodial parent is allowed to give the personal exemption to the
non-custodial parent under § 152(e)(2)

• Note → Dependents can be more than just children

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 12. Other Exclusions from Gross Income (Chapter 11)
A. Sale of Principle Residence
§ 121 – Exclusion of Gain from Sale of Principle Residence (p. 96)
• TP must have lived in home for period of 2 years (aggregated) over last 5 years.
• If he does → he does not have to claim gains of $500,000 (married filing jointly) or $250,000
(filing separate)
o Can not be done but every 2 years (§ 121(b)(3))
• Analysis:
o (1) Is it held for an aggregate of two out of the last five years? (§ 121(a))
o (2) In case of joint return, does it meet the requirement of § 121(b)(2)(A)?
 If not, go to § 121(b)(3)(A) – add individual limitations
• Also, look to § 121(c)(2)(B)
 If yes, continue with analysis
o (3) Was there a sale in the prior two years? (§ 121(b)(3))
 If no, then it is properly excludable up to $500,000 for joint return ($250,000 for
individual)
 If yes, then see whether it falls into an exception in §121(c)(2)(B) (change in
place of employment, health, or to the extent provided in regulations, unforeseen
circumstances.
• § 121(b)(2)(A): (Special rules for spouses filing a joint return)
o (i) Either spouse meets the ownership requirement
o (ii) Both spouses meet the use requirements of subsection (a) with respect to such
property AND
o (iii) Neither spouse is ineligible for the benefits of subsection (a) with respect to such
property by reason of paragraph (3) (1 sale every 2 years)
• § 121(c)(1) illustrative hypo: (TP = joint return filing) (assuming they meet § 121(c)(2)
o TP buys House1 and House2 in year 0
 House2 is the principle residence from year 0  2 and from year 5  6.5
 House1 is the principle residence from years 2  5
 Each house meets the § 121(a) ownership and use requirements.

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  TP sells House1 on year 5 and sells House2 on year 6.5
o The problem is the two years of sale from first one requirement (§ 121(b)(3))
o § 121(c)(1) applies to this:
 Here, § 121(c)(1)(B)(i) is the shorter of (I) 2 years or (II) 1.5 (1.5)
 Divided by § 121(c)(1)(B)(ii) – 2
 Which = 75%
 This 75% is multiplied by the amount of exclusion allowable (which is
$500,000) to result in $375,000 that TP is allowed to exclude (not recognize)
for sale of House2)
• § 121(c)(2)
o See § 1.121-3 (p. 1080) – Gus said he would make it clear if we meet § 121(c)(2)(B) on
the exam
 -3(c)(2)  move for 50 miles (48 miles probably okay)
 -3(d) – All you need is physician to sign off
• Cost of living (based on where you live) not taken into account.
• Have to know old law as well (See problem (1)(d) below) -- § 1034. Under the prior rules, you
needed to know about § 1034 and old § 121 (nothing like new rule…allowed one lifetime
deduction (CB p. 219).
• § 121(f) – can elect not to take

Problems (p. 223)

(1) Determine the amount of gain that TPs (a married couple filing a joint return) must include in the
gross income in the following situations:
• (a) TPs sold their principal residence several years ago for $600,000. They had purchased the
residence several years ago for $200,000 and lived in it over those years.
o $600,000 AR - $400,000 AB = $400,000 G (realized, but not recognized)

• (b) TPs in (a), above, purchased another principal residence for $600,000 and sold it 2.5 years
later for $1,000,000.
o Does not fail § 121(b)(3) – one sale ever two years
o The $400,000 gain is excluded (not recognized)

• (c) TPs in (b), above, if the second sale occurred 1.5 years later?
o The $400,000 gain is recognized (added to GI)

• (d) What result in (b), above, if TPs had sold their first residence and were granted non-
recognition under former § 1034 (the rollover provision) and, as a result, their basis in the second
residence was $200,000?
o (See CB p. 219 – Rollover of Gain)
o House 1
 $100K basis, sold for $180K realized gain
 Old law says if you reinvest the AR within two years before or after, no gain is
taxable and your basis in the new house is the same AB (here $100K) – GAIN IS
ROLLED OVER
o House 2 – Buy More Expensive House
 $200 FMV, $100K H1 AB, + $20 cash (for bigger house) = $120 AB in H2
 There is no limit. You could do this forever. AB is wiped out at death and heirs
take basis in the property = FMV
 Say if you don’t die and sell house for $300,000
 You have a gain (realized) of $180K

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 o House 3A – Buy Cheaper House (FMV > AB)
 You now buy H3 for $200K (so you pocket $100K). $100K will be gain
recognized
 And there is $80K of unrecognized gain still (and your basis is still $120)
 Under the old § 121, if you were 55+ you could exclude (one time in your life) up
to $125K
o House 3B – House FMV < AB
 Assuming no old § 121 election, what if you purchased H3 for $100K? How
much gain should your recognize now?
 You realize $200K in gain, and of that $180 is recognized. Your current
unrecognized gain is $0 and your AB is $100K
o Formula:
 Original basis + gain realized – cash taken out = New Basis
 Note that the basis rules preserve a Built in Gain

• (e) What result in (a), above, if the residence was TP’s summer home which they used 3 months
out of the year?
o Not principle residence. § 1.121-1(b)(2)…all $400K is taxable gain

• (f) What result if TP who met the ownership and use requirements is a single taxpayer who sold
a principal residence for $400,00 and it had an AB of $190,000 after TP validly took $10,000 of
post-1997 depreciation deductions on the residence which served as an office in TPs home?
o $400K - $190K = $210K of realized gain, how much is recognized?
o $10K is taxable gain (depreciate amount…prevent double dipping) -- § 1.121-1(d), §
121(d)(6)

(2) Single TP purchased a principle residence for $500,000 and after using it for one year, TP sold the
residence for $600,000 because TP’s employer transferred S to a new job location

• (a) How much gain must TP include in gross income?

o § 1.121-3(c) – if move is for more than 50 miles away, TP can get ½ of the $250,000
exclusion (through § 121(c))
o All $100,000 gain is excludable
• (b) What result in (a), above, if TP sold the residence for $700,000?
o $ 75,000 is included into income

(3) TP has owned and lived in TP’s principal residence for 10 years, the last year with TP’s Spouse after
they married. Spouses decided to sell the residence which ahs a $100K AB for $500K.

• (a) If the spouses file a joint return, do they have any gross income?
o No. It is under the $500K limitation

• (b) What result if the Spouses had lived together for two years in TP’s residence prior to their
marriage and sold the residence after one year of marriage for $500,000.
o The ownership requirement is imputed through §121(d)(1)

• (c) What result in (a), above, after one year of marriage TP pursuant to their divorce decree deed
one-half of the residence to Spouse and Spouse lived in the residence while TP moved out and,
one year later they sold the residence for $500,00?
o The ownership requirement is imputed through § 121(d)(3)(A) (see also § 1.121-2(3)(ii))
o Amount excluded

• (d) What result in (a), above, if after one year of marriage TP pursuant to their divorce decree
deeded one-half of the residence to Spouse and TP continued to occupy the residence while
Spouse moved out, and , one year later, they sold the residence for $500,000?

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 o The use requirement is imputed to Spouse through § 121(d)(3)(B)
o Amount excluded

13. Business Deductions (Chapter 14)

• Code → splits deductions into 2 sections

o 1. Biz/Trade Deductions → all fall above the line!

 § 162 → deducting expenses
 § 165(c)(1) → deducting losses
 § 167(a)(1) → depreciation of assets deductions

o 2. Deductions for Production of income and activity engaged in for profit (non-biz
activities) → some may fall below the line!
 § 212(1)(2) → deducting expenses
 § 165(c)(2) → deducting losses
 § 167(a)(2) → depreciation of assets deductions

 Non-biz activities → stuff that TP uses for production of income but does not rise
to level of trade/biz activity
• Buying stock for self
• Renting out house

A. Business Deductions
§ 162 → Trade and Biz Expenses
• Generally → there shall be allowed as a deduction all the
o 1. Ordinary and necessary expenses
o 2. Paid or incurred during the taxable year
o 3. In carrying on

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 o 4. Any trade or biz

• Including following deductions

o Reasonable allowance for salaries or other compensation for personal services
actually rendered
o Traveling expenses while away from home in the pursuit of a trade or biz and
 Including amounts expended for meals and lodging (meals → 50% limit)
o Rentals or other payments required to be made as a condition to the continued use or
possession, for purposes of the trade or biz, of property to which the TP has not taken or
is not taking title or in which he has no equity
o Health Insurance costs for self employed → 100%
• Does not include
o Illegal bribes/payments
o Certain lobbying and political expenditures (attempts to influence legislations)

“1. Ordinary and Necessary”

• Welch v. Helvering (1933) (p. 314)

o TP → was secretary of bankrupt company. B/c he wanted to stay in industry – he chose
to pay off the debts of the company. There was no legal obligation to do so.
 He then claimed deductions for amounts he paid.
o Issue → are the amounts deductible as ordinary and necessary biz expenses?
o CT → NO – these may be necessary but were not ordinary but were in fact
extraordinary. Cannot be deducted
 TP turned $ into a capital expense.
 TP’s good will → is a capital expenditure b/c is capital asset
• Not a depreciable asset!
• TP → can never sell this – so will never get $ back.

• Ordinary → a transaction of common or frequent occurrence in the type of biz involved

o Even if the expenditure is unique for the particular TP
o Is variable affected by time, place, and circumstances
 See pg. 316 FN’s for examples of ordinary v. non ordinary expenses
o Test: Is it common to the TP’s business group (within industry)?  if so, it is ordinary

• Necessary → appropriate and helpful to the development of TP’s trade or biz

o Very low standard – hardly ever contested by the courts.

“2. Expenses”

The Test – Useful Life Substantially Beyond the Taxable Year

• ISSUE: Is the cost/payment either an expense or an expenditure?
• Capital Expenditure: § 1.263(a)-1,-2 – made to increase value or restore property
• Business Expense: § 1.162(a)-4 – Ordinary efficient operation condition vs. arrest deterioration

• Expenses → are deductible right away

o Reg 1.162-4 → repairs – can be deducted as long as they do not add to the value of
the property or prolong its life
• § 263 → Capital expenditures → are NOT deductible
o Money spent for new buildings are for permanent improvements or betterments
made to increase the value of any property or estate.
 Are capital in nature and NOT deductible.
o Capital assets are either

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  Depreciable → recovers $ over time
 If not depreciable → TP recovers $ when sell asset

Lincoln Savings and Loans → When a separate and distinct asset is created
• The amount expended in doing so are capital expenditures.

Midland Empire Packing Co. v. Comm (1950) (p. 319)

• Meatpacker Cellar case → TP’s cellar where he hung meat was contaminated by neighbor. TP
had to spend $ to fix concrete wall
• Lynchpin: Prolong the useful life or just live out useful life?
• This was viewed as “live out the useful life” -- Why?
o Expected life – WHEN? Before the problem
• Analysis:
o (1) Look to before the repair was needed to compare to post-repairs to see if it was
an expense or an expenditure.
o (2)If it is just a repair in normal business, look to whether it is a benefit beyond the
taxable year.
• Not extend its life, but to continue on same scale
o Made repairs in order that it might continue to operate its plant
o After expenditures, the plant did not operate on a changed or larger scale, nor was it
thereafter suitable for new or additional uses
o Not improving here, just repairing.
• Drive in case (Mt. Morris, p. 323) → TP built drive in – which caused erosion to neighbor’s yard
due to excavations TP did for drive in. TP had to spend $ to fix.
o Costs → are Capital Expenses and are NOT deductible b/c not a repair
 TP should have known from the beginning this problem and should have spent
the $ to build it right
• They knew they needed draining pipes installed
• This is not a case where an intervening event caused the need to fix.

Indopco v. Commission (1992) (p. 326)

• TP was company that deducted expenses used in connection w/ friendly takeover by other
company → deducted $ spent on investment banker’s fees and legal fees as ordinary and
necessary expenses .
o IRS → says expenditures are capital in nature and not deductible under § 263
• CT → agreed w/ IRS.
• At issue → difference between § 162(a) expenses that are deductible as biz expenses and
§263 capital expenditures where are not deductible
o § 263 → allows no deduction for a capital expenditure –
 Any amount paid out for new buildings or for permanent improvements or
betterments made to increase the value of any property or estate.
 If deemed to be capital asset → must be amortized or depreciated.
 If capitalized - TP has intangible asset on books w/ huge basis that TP can only
take as loss when company is liquidated
• Future Benefit Test → expenditures are capital in nature if they serve long term betterment
o If you create a separate and distinct asset → it will be capitalized.
o Duration and extent is the key
 If short term → will be Biz expense deductible.
 If has future benefit → capital in nature.
• Here → b/c of the changes in the companies – there are future benefits that will go far into the
future and therefore $ spent was capital expenditures (synergy, Unilever’s resources, one
shareholder, etc.)

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 o This capital expenditure is not depreciable
 Must be carried on books until liquidation of the company
• TP relied heavily on Lincoln (p. 328-329) as basis why he can deduct
o TC: This is only one type, here it is a long-term benefit not like paying light bill to stay in
business for today
o Lincoln stood for the proposition that: a TP’s expenditure that “serves to create or
enhance a separate and distinct asset should be capitalized under § 263.” However, this
does not mean that ONLY expenditures in this manner are to be capitalized.

Post INDOPCO
• Reg. require capitalization
o (1) an amount paid to acquire, create, or enhance an intangible asset
o (2) an amount paid to facilitate an acquisition or creation of an intangible asset
o (3) an amount paid to facilitate a restructuring or reorganization of a business entity or a
transaction involving the acquisition of capital, including a stock issuance, borrowing, or
recapitalization
• Capitalize an amount paid to “facilitate”
o (1) an acquisition, creation, or enhancement of an intangible asset
o (2) restructuring or reorganization of a business entity or a transaction involving the
acquisition of capital
• Hypos and Cases
o Company building
 4 shingles fall off roof – repair is deductible
 whole roof blows away → repair is capital expenditure

o Note → this is only for biz

 $ spent fixing roof on personal home – is NOT deductible under § 262
 TP → will want to make home repairs – capital expenditure
• Increases basis to home – will help for tax purposes.
o Water case → TP’s pipes to deliver water to community – source dried up so when after
new source. New source left water deposits in pipes. TP had to spend $ to clean walls
of pipes. Costs to clean → were deductible as biz expense. Life of pipe – was not being
extended nor was anything new being created
o Norwest v. Commission – Unanticipated expenses that would be deductible a biz
expense if incurred in isolation must be capitalized when incurred pursuant to a
plan of rehabilitation.

Problems (p. 334) – APPLY § 1.263(a)-1(a)(2) (p. 1233) and § 1.162(a)-4 (p. 1106)
• (1) LL incurs the following expenses during the current year on a ten-unit apartment complex.
Are they a currently deductible repair or a capital expenditure?
o (a) $350 for painting three rooms of one of the apartments.
 Expense
o (b) $1500 for replacing the roof over an apartment. The roof had suffered termite
damage.
 Tough Call
• How is termite damage different from oil seeping in? Not really, so
looks like a repair
• Or, what if you treat them as 10 separate assets? What if it were just
wear, what if it was a hurricane?
 P. 1106, p. 316, Fn. 1 – FACT AND CIRCUMSTANCE DRIVEN
o (c) $500 for patching the entire asphalt parking lot area
 Repair
o (d) $750 for adding a carport to an apartment.
 Capital Expenditure

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 o (e) $100 for advertising for a tenant to occupy an empty apartment.
 Business expense (p. 1105)
 But, argument can be made that it is a capital expenditure (garner
image/goodwill)
NOT ON EXAM:
• (2) I believe they are consistent with the principle, but that it looks more to the “separate and
distinct intangible asset.”

• (3)
o § 1.263(a)-5(a)(1) – Employee compensation is deductible as not used to “facilitate a
transaction”
 FN 5 on pg. 332
 pg. 1240 Fn 18 – 1.263(a)-4(e)(4) – Not costs to facilitate transaction
o Construction of a new building:
 Capital expenditure

3. “Carrying On” – TP has to be in the biz to deduct carrying on expenses

Morton Frank (1953) (p. 335) – Just investigatory costs, not carrying on of a trade or business
• TP’s wanted to buy newspaper or radio station
o Deducted $ spent while traveling across country looking for radio/TV station to buy
• CT → travel expenses and legal fees spent in searching for a newspaper biz to buy
o Cannot be deducted under § 263
o Expenses of investigation and looking for a new biz – are not deductible
 Pursuit → does not mean ‘searching for’
• TP has to be engaged in the trade or biz at the time expenses are incurred to deduct them →
here they were NOT in the biz.
o Had TP been seeking to expand radio biz – would have been able to deduct
• $ spent investigating a new biz/trade
o are capital in nature – and are not deductible
• TP → must be in the same biz in order to deduct
o If moving from 1 biz to another kind of biz – cannot deduct costs incurred
o Example → an attorney who leaves law practice to open up real estate practice cannot
deduct $ spent on move
• Being an employee constitutes carrying on a trade or business (p. 339)
§ 195→ Start up expenditures (p. 200)
• No deductions are allowed for start up costs, could be allowed as an capital expenditure
• However → TP may elect to amortize expenses incurred in starting up a biz (those expenses
that would have been deductible had TP been in the biz already)
o If elected – must deduct prorated equally over a period of at least 60 months
 Beginning → in the month TP opens the biz/trade.
• TP → must actually enter the trade/biz to elect this
• Definitions of start up expenditures
o Any amount paid or incurred in connection w/
 1. investigation the creations or acquisition of an active trade/biz or
 2. creating an active trade or biz or
 3. any activity engaged in for profit and for the production of income before the
day on which the active trade/biz beings – in anticipation of such activity
becoming an active trace/biz.
• § 195(b) – Election (otherwise, capitalized)
• What § 195 does:
o If you are getting a 5 year lease, the costs of the attorney is to be capitalized b/c it
couldn’t be a § 162 deduction (creating asset here with value of more than one year)
 Same result if you remolded

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 • Analysis
o (1) § 195(c)(1) have to have 1 of 3 situations
o (2) § 195(c)(1)(B) if within trade or business, must be a “currently deductible expense”
 I.e., falls under § 162 – (to prevent capital expenditures from being deducted)
• How Taken:
o (1) First Year
 § 195(b)(1)(A) – Allowed a deduction in the amount of the lesser of the startup
costs or $ 5,000 (but the amount is reduced starting at $50,000)
o (2) If remainder over $5,000
 (1) If you have $15,000 in start-up costs in October, Year 1 – you take that
$5,000 for starters
 (2) The remaining $10,000 is divided by 180 = “x”
 (3) Since there are three months remaining in Year 1, you are allowed 3x + the
$5,000 for the first year.
 (4) In Year 2, you take (12/180) x 10,000
 (5) Continue this for Year 3-15 (note, it expires in 15 years automatically)
 (6) In Year 16, you take (9/180) x 10,000
• If corp2 buys copr1 (which is currently deducting under § 195), Corp2 assumes it.
o Sole proprietorship/partnership viewed as sale off of each asset (cannot ad up all basis…
have to work out individual assets)
• If Year 1 = $52,000 in start up expenditures, only $3,000 is allowed in the first year, but don’t
forget to still apply § 195(b)(1)(B)

Problems (p. 342) (1) Determine the deductibility under §§ 162 and 195 of expenses incurred in the
following situations.

• (a) Tycoon, a doctor, unexpectedly inherited a sizeable amount of money from an eccentric
millionaire. Tycoon decided to invest a part of her fortune in the development of industrial
properties and she incurred expenses in making a preliminary investigation.
o Not same trade or business  apply § 195
• (b) The facts are the same as in (a), above, except that Tycoon, rather than having been a doctor,
was a successful developer of residential and shopping center properties.
o Check to see what IRS said, but Gus thinks that all under RE = same business (§ 162(a))
• (c) The facts are the same as in (b), above, except that Tycoon, desiring to diversify her
investments, incurs expenses in investigating the possibility of purchasing a professional sports
team.
o Not same trade or business  apply § 195
• (d) The facts are the same as in (c), above, and Tycoon purchases a sports team. However, after
two years, Tycoon's fortunes turn sour and she sells the team at a loss. What happens to the
deferred investigation expenses?
o § 195(c)(2)(B) (Loss or Gain – doesn’t matter)
o Say that she closes the business in the on September of the third year (same as “How
Taken” above)  gets:
 Deduction in Year 3 of: (9/180) x $10,000
 Gets a loss of: (156/180) under § 165(c)
 Note, that when you are calculating start up loss, AR = 0

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 B. Business Deductions
- § 162 → Deduction for all ordinary and necessary expenses paid or incurred during the taxable
year in carrying on any trade or biz including
o Reasonable allowance for salaries – Cant pay son $100K for $10K job. $1mil limit for
CEOs

- § 62(a) → Above line deductions for

o 1. Trade and Biz Deductions
 Biz expenses → deduct all out of pocket expenses incurred during and
attributable to trade or biz.
 Applies to Employers and Self Employed
 Does NOT apply to employees →
• Employees doe not get to take deduction under § 62(a)(1) for out of
pocket expenses.

o 2. Certain Trade and Biz Deductions of Employees → See Reg. 1.62-2

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  Reimbursed expenses of employees→ deductions allowed for expenses paid or
incurred by TP, in connection w/ the performance by him of services as an
employee, under a reimbursement or other expense allowance arrangement w/
his employer.
• If the $ employees gets is under a reimbursement or other expense
allowance arrangement by the employer for employee’s out of
pocket expenses
o Employee gets to deduct the $ above the line
o Assumption → Employee must also take reimbursed $ for
services into income
 Effect → is a wash.
 Note → Reg 1.62-2 → is different → Follow the regs!

- § 62(c) → Reimbursements and other expense allowance arrangements

o Arrangement → does NOT qualify as reimbursement/expense allowance if
 Employee is not required to substantiate his expenses or
 Employee can keep any excess amount

- Reg 1.62-2(c)→ Reimbursements and other expense allowance arrangements

o Follow this over the Code!

o Accountable Plan → means plan meets all 3 requirements of (d → biz connections), (e

→ substantiation), and (f → returning amounts in excess of expenses). Need all 3 – if
you flunk even one – you have a non-accountable plan
 Treatment of Payment → amounts paid under an accountable plan are
excluded from employee’s GI
• No GI – No Deduction (wash)
• Treating employee as employer’s agent

o Non-Accountable Plan → arrangement does not satisfy 1 or more of d, e, and f.

 Treatment of Payment → amounts paid under non-accountable plan are
included in employee’s GI → treated as compensation for services
• Expenses attributable to amounts included in employee’s GI may be
deducted
o If employee can substantiate the full amount of his
expenses
• Deduction → is a miscellaneous itemized deduction
o Subject to 2% of AGI and
o 50% limitation on meals and entertainment expenses under §
274(n)
 so → not full benefit
o Point → Regs trying to encourage accountable plans – easier to track 1 employer than
many employees.
- Compare → § 132(d) → working condition fringe → deals w/ employer providing property or
service that employer has to offer in market place.
o If employee went out in Market place and bought service/property from 3rd party and
would have been able to deduct b/c used in biz/trade but employer reimburses for
payment instead
 It is not treated as income – but not deductible either
• Is a wash

- Gus’s connecting the Dots

o § 62(a) – defining above the line deductions for individual TP’s (this is where they want
them)
 if not listed → need to start itemizing

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 o § 62(a)(1) → above the line deductions are allowed for
 employers and self employed only
• employees → deductions are below the line
o § 62(a)(2)(A) → If employee paid out of pocket for biz expense and employer is
reimbursing
 employees → take into income $ reimbursed but can deduct out of pocket
expense above the line
o § 62(c) → helps to define reimbursement
 if employee can retain excess $ - extra $ is income
o § 274(e)(2) → expenses treated as compensation
o Regs 1.62-2(c)(2) → to have Account Plan → says to meet d,e,f
 If employee fails to return excess $ → does not make whole plan turn into Non-
Account plan
• Only extra $ is treated as non-account plan
o Reg 1.62-2(c)(3) → Non – Account plans
o Reg 1.62-2(c)(4) → Payment under account plans – does NOT go into Employee’s GI
and not deductible → is seen as employer’s expense
o Reg 1.62-2(c)(5) → Non Account plan $ → is put in Employee’s GI
 May be deducted – but must be substantiated and can only be deducted as
miscellaneous itemized
• Code – is treated this as compensation for services.
o Point → Follow Regs → NOT code

C. Miscellaneous Business Deductions

§ 274 – Disallowance of Certain Entertainment, Etc. Expenses (p. 248)
• Disallowing deductions allowed elsewhere. The general driving limitation here is personal living
expenses (which are not deducted §262) – otherwise, it would be subsidizing personal living
expenses.
• Entertainment and meals may be deducted if:
o TP establishes the item was directly related or, directly preceding or following a
substantial and bona fide biz discussion that such item was associated w/ the active
conduct of TP trade/biz
 If directly related → can be deducted
• Take client to golf/eat – can deduct as long as biz discussed
 Biz meals: cannot be lavish/expensive and TP deducting expense must be
present
• If traveling away from home → can eat alone

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 • 50% limit on deductions when applied to employees for entertainment and meals
o TP has to eat anyway – so no reason to make us all subsidize all food.
• Spouse/dependent → deductible only they are employed by TP
• Entertainment Facilities → NOT Deductible (summer yacht, club dues, golf dues)
o But activities related to use of facilities – are 50% deductible if rules for deduction of
entertainment are met.
 Biz TP takes client skiing → 50% off lift tickets, ski rentals and meals.
o 50% deductible rules → for face value of tickets only
 if you scalp a $10 ticket for $100 – only claim a $5 deduction
 Also → luxury sky boxes – is a facility and non-deductible beyond the 50% cost
of a regular ticket
§ 274(d) → Substantiation Required → no deduction/credit is allowed
• Unless → TP substantiates w/ adequate records or sufficient evidence the amount spent,
time and place of travel/entertainment etc, biz purpose for the expense, biz relationship to TP
of persons entertained.
o Need receipt for anything spent over $75.
§ 274(e) → TP may deduct the following →
• Food and beverages TP provides to employees on the biz premises
• Expenses for entertainment, amusement, or recreation treated as compensation to
employees
o Employee → treats as wages
• Reimbursed Expenses
o Any money TP reimburses employee, when employee incurs the expenses
Uniforms → cost to obtain and maintain are deductible if
• 1) uniforms are specifically required as a condition of employment and
• 2) they are not of a type adaptable to general or continued usage to the extent that they take
the place of ordinary clothing
o examples → fireman, policeman, baseball players, etc
o Military uniform → are for general use – no deductions allowed
Advertising → are deductible in the year in which they are incurred or paid
• Even if benefits extend for number of years (magazines, TV, sports programs)
o Unless they qualify as capital – like costs of billboard or advertising sign that lasts for
years
Dues → paid to organization directly related to one’s biz are deductible under § 162
• Att’s fees paid to local bar and employee’s labor union dues
Lobbying Expenses → generally non deductible
Expenses for education → normally deductible → see Reg 1.162-5
• Includes → maintaining or improving skills, meeting requirement of employer or requirements
of law or regulations (CLE’s)
• Must be in trade/biz

D. Business Losses
§ 212 → allows for individual to deduct expenses incurred for the production or collection of income
• so → can deduct expenses related to managing investment portfolio

§ 165(a) – Losses (p. 152)

• Individuals only can take losses in § 165(c)
• How do you take the loss?
o § 1001(a) – AB – AR = G(L)
o § 1001(c) – recognized, unless other provision prevents it.
• § 165(c) – Switchboard for all losses
o (c)(1) – Event has to occur: sale or other disposition of property

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 o (c)(2) – Chapter 15 (transaction entered into for profit)
o (c)(3) – Not covered in exam (can include theft)
 § 165(h) – Above $100, 10% greater than income
 Can have casualty gain (bigger than basis) taxable
• § 165(i) – Disaster relief

14. Depreciation (Chapter 14)

A. Depreciation In General
• § 167 → allows the deduction for tangible property
o Tangible property → look in order at → §179, § 168
o Intangible property → look in order at → § 197, §167
• § 168 → how to calculate the deduction for tangible personal property § 167 allows
• § 179 → Bonus depreciation → for tangible, personal property used in trade/biz
o Applies to § 168 tangible property for 3-5-7-10-15-20 property
• § 197 → allows deduction for some intangible property (goodwill plus more)
o Requires amortization

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 o If property falls under § 197 → MUST take here.
 If it is not there → can fall back on § 167(f)
• After you depreciate, your basis goes down under §1016

• § 167 → Depreciation
o Allows a depreciation deduction a reasonable allowance for the exhaustion, wear,
and tear
 1. of property used in trade or biz (above the line deduction under §162a)
 2. property held for the production of inc. (misc. below the line ded)
• Property/land/securities not used in connection w/ trade or biz of TP or in
an income producing activity of TP cannot be depreciated or amortized.
o Adjusted Basis = Unadjusted basis + any capital expenditures on the property – any
depreciation previously allowed/allowable.
 If TP does not choose a depreciation method → IRS will use the straight line
method

• § 168 → Accelerated Cost Recovery System → ACRS

o Applies to tangible (real and personal) property
o Tells you how to calculate the deduction § 167 allow
o Will depreciate property at rate faster than its economic decline.

• § 168(a) → Depreciation of § 167 tangible property shall be determined by using

o 1st → the applicable depreciation method under § 168(b)
o 2nd → the applicable recovery period under § 168(c) and
o 3rd → the applicable convention under § 168(d)

o Note → whatever rules TP applies when he placed property into service

 Must be continuously applied to the property until fully depreciated
• Made determination once – and stick w/ it to the end of that asset

• § 168(b) → 3 methods to depreciate § 167 tangible property

o 1. 200% declining balance method

 Use for → 3,5,7,10 year property
 TP → may elect 150% or Straight Line method

o 2. 150% declining balance method
 Use for → 15 or 20 year property
 TP → may elect Straight Line method
• May not elect 200%
o 3. Straight Line method
 Use for → Non-residential real property and Residential real property
 TP → No elections available

o § 168(b)(5) → can always elect to go slower → but NEVER faster.

 Election → may be made w/ respect to 1 or more classes of property for any
taxable year and once made w/ respect to any class shall apply to all
property in such class placed in service during such taxable year
• If elect to have 3 year property go from 200% to straight line
o ALL 3 year property placed in service that taxable year will also
be done straight line.
• At same time → TP may leave all 5 year property under 200%

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  Once made → election is irrevocable.

• § 168(c) → Applicable recovery period → see chart

o 3-5-7-10-15-20 year property → has a 3-5-7-10-15-20 year recovery period

o Residential Rental property → 27.5 year recovery period
o Nonresidential real property → has 39 year recovery period
 § 168(g) can change last two to 40 years

• § 168(d) → Applicable Convention

o Generally for 3-5-7-10-15-20 year property → will be the half year convention
 Unless 40% or more of the property was placed into service w/in last 3 months of
the year → use Mid-Quarter convention
o Real property (both nonresidential and residential rental) → mid month convention

• Mid-year convention → for 3-5-7-10-15-20 year property

o Basically → get half year allowance for year 1 and half year allowance for last year –
but full allowance for all year in between
 Example → 5 year property that can be depreciated $10K = $2000/year
deduction or 20% each year. Will take 10% in year 1 and year 6 but full 20%
years 2-5
• Year 1 $1000 deduction (1/2 year deduction)
• Year 2-5 $2000 deduction each year (Full year deduction)
• Year 6 $1000 deduction (1/2 year deduction)

• Mid Quarter Convention → for 3-5-7-10-15-20 year property when 40% put in last 3 months
o Basically – if greater than 40% of the aggregate base of property is placed in
service during the last 3 months of the year (Oct – Dec) – TP cannot take ½ year
deduction – but takes mid quarter for 1 year, straight line for middle years, mid-
quarter for last year. There are 8 mid quarters in a year = 1.5 months each
o Applies to ALL property placed in service during year.

Jan – Mar │ Apr – June │ July – Sept │ Oct – Dec

7/8 5/8 3/8 1/8
 Example → more than 40% of all property is placed into service in Oct
• Property put in → Oct
o Year 1 = 1/8th Last year = 7/8th
• Property put in → June
o Year 1 = 5/8th Last year = 3/8th
• Mid-month Convention → for real property (See XVII and XVI)
o Basically → there are 24 mid months in 1 year = .5 months each. If TP puts into
service in Oct → gets 2.5 months worth (of depreciation for year 1. Year 2-39 →
goes strait line for middle years. Year 40 → gets 9.5 months worth of depreciation.
(placed in Jan get 11.5 months or 23/24th and if placed in Dec get .5 months or 1/24th)
From Betty’s outline → possible that 27.5 property will spill over into year 30.
 Example → 39 year property is put into service Oct
• Year 1 2.5 months deduction (5/24th)
• Year 2-39 full year deduction for each year
• Year 409.5 months deduction (19/24th)

Jan │ Feb │ Mar │ April │ May │ June │ July │ Aug │ Sept │ Oct │ Nov │ Dec
23/24 21/24 19/24 17/24 15/24 13/24 11/24 9/24 7/24 5/24 3/24 1/24

Steps to depreciation of Tangible property

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 o 1st → Classify the property under → § 168(e)(1)
 Gus will give us the property’s class life → need to look at chart to convert
into 3-5-7-10-15-20 year property
• Example → if class life of property is 4 year of less = 3 year property
 § 168(e)(2) → Residential rental or nonresidential real property used in
trade/biz or held for production of income
• Residential rental → any building/structure if 80% or more of the gross
rental income from such building is rental income from dwelling units.
o Can be house or apartment
o If any portion is occupied by TP/owner → Gross rental income
shall include the rental value of the portion so occupied
• Non-residential real property → commercial property

o 2nd → Determine appropriate depreciation method under § 168(b)

 200% declining balance → 3-5-7-10 year property
 150% declining balance → 15-20 year property; 3-5-7-10 year by election
 Straight-line → residential rental/nonresidential real property used in trade/biz or
held for production of income, 3-5-7-10-15-20 year by election

o 3rd → Applicable Recovery Period under § 168(c)

o 4th → Get the convention under § 168(d)

 Mid-Month → Residential rental and nonresidential property
 Mid-Year → 3-5-7-10-15-20 year property
 Mid-Quarter → 3-5-7-10-15-20 year property if 40% was put in during last 3
months of the year.

o Whatever rules you apply to a piece of property TP is locked in → TP must apply same
rules until asset is fully depreciated
 When determining depreciation for 3-5-7-10-15-20 year property
• All property w/in same class category – must be treated the same
o TP has 3 assets w/ 7 year class life → All 3 assets must be
depreciated the same way

Illustration (p. 427) of ACRS

(Note that you can achieve similar result on p. xv – Depreciation tables, by taking basis x that %)
• Facts: $8,000 asset; 5-year property classification; Convention = half year; Straight-line Method –
Depreciates at 20% for 5 years

SL ACRS

Year 1 20% 40% (200% of SL)  ½ year convention

($800) ($1,600)
Balance $7,200 $6,400

Year 2 ($1,600) ($2,560) (40% of $6,400)

Balance $5,600 $3,840

Year 3 ($1,600) (20%) ($1,536) (40%)

Balance $4,000 $2,308

Year 4 ($1,600) (20%) ($922) (40%)

Balance $2,400 $1,381

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Year 5 ($1,600) (20%) ($921) (20%)
Balance $800 $461

Year 6 ($800) ($461) (1/2 * 20%)

Balance $0 $0

• Year 1 = 1/5 < 40%

• Year 2 = 1/4.5 < 40%
• Year 3 = 1/3.5 < 40%
• Year 4 = 1/2.5 = 40%
• Year 5 = 1/1.5 > 40%
o Switch in this year to SL – SWITCH WHEN SL PRODUCES BIGGER #
• Year 6 = .5/1.5 > 40%

§ 168(g) → Alternative Depreciation System for Certain Property (p. 162)

• (g)(7) → If TP elects to use the alternative depreciation system w/ respect to any class of
property
o TP must use alternative system for all property in the class placed into service
during the tax year
 Exception → Nonresidential and Residential rental real property
• Election can be made separate w/ respect to each property
o Election → is irrevocable
• (g)(2) → If TP elects → must use the Straight Line Method, applicable convention under
§168(d) and the following recovery periods
o Residential Rental and Nonresidential Real property → 40 years
o 3-5-7-10-15-20 year property → Use Class life
o Personal property w/ no class life → 12 years

§ 1016(2) – AB Rules
• If you take the depreciation deduction and method is allowable, you are okay
• If you make incorrect deduction, you still have to reduce your basis by that amount (no double
dipping)
• You must take the depreciation, if not…you lose it. Even if you don’t have income to offset
against, you an treat it as a NOL

§ 168(d)(3) – Anti-Abuse Rule (p. 159)

• If all 3-20 property is placed into service in December:
o W/o this rule, you’d be able tot take ½ of the full year
o Rule extends to the last three months. If you have more than 40% of your 3 to 20 year
property placed into service in the last quarter, then you use mid-quarter (APPLIES TO
ALL PROPERTY)
• What if you placed 41% in the last quarter and 59% in January of Year 1? TP is better off
o 8 quarters
o For 59% take 7/8 (quarters)
o For 41% take 1/8
o 7/8 X 59% + 1/8 X 41% > 100%

§ 179 – Bonus Depreciation (p. 195) -- Tangible, Personal, Property, Depreciable

• See CB p. 434  Apply § 179 before § 168(b)
• Allows TP to deduct up to the “applicable” amount – costs of §179 property the year that TP
places the §179 into service
• § 179 property → 3-5-7-10-15-20 year personal tangible property used in trade/biz
o NOT real property, property held for production of income, intangible property
• Limits → on aggregate of property
o TP can deduct up to $100,000 in 1 year

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 o Deduction cap is reduced $ for each $ of property in excess of $400,000 limit
• Example of limitation
o If assets worth $75K → TP can deduct all $75K
o If assets worth $300K → TP can deduct $100K
o If assets worth $415K → TP can only deduct $85K
 Because for every $ over $400K – must reduce the $100K bonus
depreciation by the same $. This was $15K over $400K, so TP must
reduce $100K – $15K for total of $85K
o If assets worth $500K → TP does not get bonus deduction
 Is $100K over the limit – so the bonus is wiped out totally
• Example of application
o If you placed in service $250K  you get a $100K § 179 deduction
 With the $150K left, you go to § 168 (you get § 168 in addition to § 179)
o If you have two pieces of property (3 year worth $125K and 15 year worth $125K)
 You still deduct the § 179 100K
 But, how is the remaining $150K allocated? You get to choose
 Which do you choose?
 TAKE all off 15 year b/c you get your 3 year depreciation faster
• § 167(d)(3) Anti-Abuse rule applies
• For small business, this rule allows ease of administration

• § 179(b)(3) → Carryover allowed

o TP cannot allow bonus depreciation to create a net operating loss – but can
carryover loss to next year
 Year 1 TI w/out § 179 = $50K.
§ 179 bonus depreciation = $80K
- $30K → cannot have
• TP → can only depreciate $50K – but can carry the extra $30K over
to next year

 Year 2 TI w/out § 179 = $200K

§ 179 current bonus = $80K
Year 1 carryover = $30K .

Total § 179 = $110K → but cannot take all b/c of $100K cap
TP can take $100K bonus depreciation → and carry over to next year $10K

 What if Year 2 TI
§ 179 current $110K
Year 1 carryover $30K

Total § 179 = $130K.

TP must carry over $40K to next year for 2 reasons
1. $10K carried over b/c of $100K cap
2. $30K carried over b/c cannot create loss
Basis $300,000
• Pg 439 Text → How to depreciate property 3-5-7-10-15-20 year tangible
§ personal–property
179 $100,000
o 1st → TP takes bonus depreciation under § 179 AB $200,000
o 2nd → regular depreciation under §168 and §167
o 3rd → § 280F deduction If 10 year property and placed in service
before Oct →
• Example → for 3-5-7-10-15-20 year tangible personal (200K/10 = $20K/year)
property Year 1 deprecation = $10000
o TP has basis in 10 year property worth $300,000 Year 2-10 dep = $20K
Year 11 = $10000

If placed in between Oct-Dec

77 Year 1 depreciation = 1/8th of year
Year 2-10 = full $14K
Year 11 = 7/8th of year
 1st → Take § 179 bonus
2nd → Take § 168 Straight Line depreciation
Jan – Sept → use Half year
Oct – Nov → Use Mid Quarter

See York Outline for Reg. and BIL/BIG analysis on p. 65-66

B. Depreciation of Intangibles

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§ 197 Amortization of Intangible property (p. 201)
• Includes → good will, going concern value, patent, copyrights, covenants not to compete,
customer-based (see pg. 202 of code book for whole list)
o Before → could not depreciate these intangible property b/c hard to determine useful life
for. Sup CT (in case with purchase of newspaper subscriber list Newark Ledger)
changed and § 197 came into code to tell you how to
• 15 years → intangible property will be an amortization deduction of basis ratably over 15
years
o Beginning in the month intangible was acquired.
 Put in Oct
• 1st year→ 3/12th
• 2-15 years → straight line depreciation
• 16th year → 9/12th
o Get full month – no matter what part of month you acquire. If on 10-31 – get to
count full month of Oct
• Is a straight line depreciation
• What if it is a covenant not to compete
o For 5 years → Still must amortize for 15 years
o For 17 years → still must amortize for 15 years
• § 197(e) Exceptions: (see also § 167(a)-14)
o (e)(4) – Not acquired, acquired separately
 If you aren’t acquiring a trade or business or substantial part
 Pay off someone not to compete
o If fails, goes back to § 167 and if its useful life is reasonably ascertainable, it is amortized
• NO Election!
o If asset falls in list under § 197, TP is stuck w/ amortization
• If asset not under § 197 → TP can fall back on 167(f)
o But can only use if useful life can established w/ accuracy – if not, TP is out of luck

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 C. Funds Used to Help Build a Capital Asset
Problem pg. 425 → #2(a)
- § 263(a) → says no deduction shall be allowed for any amount paid out for new
buildings…” So if TP pays for salaries or for painting etc., in construction of a new building – the
expenses are capitalized an the total costs of the building is then depreciated assuming the § 167
or § 168 requirements are met.
o If Company owns trucks that are used during the year exclusively in constructing a
new storage plant for the company, is Company allowed a deprecation deduction
for the trucks during the year?
 Answer → No – both the costs of the trucks and employee’s salaries must
be capitalized, not depreciated.
 TP will recover the cost of the trucks as he depreciates the cost of the building.
Costs of trucks was a cost of creating the asset just like salaries and building
supplies.
• So → TP will add the costs of the trucks to the building and then get
$ back as he depreciates the building
 TP → can start to depreciate the building once it was placed into service.
o Note → that if TP can find a way to put the trucks into everyday use, then they are
property held for the production of income and the costs can be deducted if used to carry
on trade/biz

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 15. Deductions for Profit-Making, Nonbusiness Activities
(Chapter 15)

A. § 212
§ 212 – Expenses for Production of Income (p. 210)
• For individual TP – the following deduction of ordinary and biz expenses are allowed
o To produce or collect income
o To manage, conserve, or maintain property held for production of income
o In connection w/ the determination, collection, or refund of any tax
• These activities → do not raise to level of biz/trade activities that §162 allows for above line
deductions
• Above the line?
o § 62(a)(4) → allows only rent and royalties income under §212 to be deducted above
the line
o All other § 212 deductions → are below the line miscellaneous deductions subject
to 2% AGI floor.
• If you are an attorney, and you own rental property and you repair it  § 212 deduction
o Depreciate under § 167(a)(2)
o Sell for loss: § 165(c)(2)

Higgins v. Commissioner pg. 445 → TP had extensive investments in real estate, bonds and stocks,
and he spent a lot of time overseeing these investments. He even hired others to help him and rented
offices for this purpose. He claimed the office rent and salaries were deductible under § 162 as ordinary
and necessary biz expenses. Court → said these activities did not constitute the carrying on in a
biz/trade.
• After case → Congress enacted § 212 to allow deductions in this type of situation – but will only
be below the line unless TP is doing all this to collect rents/royalties

Reg 1.212-1 → Lists nontrade/nonbiz expenses that are deductible under § 212
• a-2 → TP has an ordinary and necessary biz expense if he paid $ for production of income which
is required to included on Fed income tax forms, $ spend for management, conservation, or
maintenance of property held for production of such income, and in connection w/ the
determination, collection, or refund of any tax.
• c → expenses incurred for primarily sport, hobby or recreations → not deductible
• d → expenses must be ordinary and necessary – be reasonable in amount and bear a
reasonable and proximate relation to the production of the taxable income
• g → fees for services of investment counsel, custodial fees, clerical help, office rent etc, are
deductible but only if TP incurs them for production of the taxable income
• k → expenses incurred in defending or perfecting title to property, in recovering property,
developing and improving property – all add to the basis of the property, are NOT
deductible
• l → all expenses by TP in connection w/ determining, collecting, refunding any tax is (both federal
or state or local) deductible
• m → expense paid by Tp in contesting a liability asserted against him does not become
deductible by reason of fact the property held by him for the production of income may be
required to be used or sold for the purposes of satisfying such liability

Reg 1.262-1(b)(7) → Items not deductible → generally attorney’s fees and other costs paid in connection
w/ a divorce, separation, or decree for support are not deductible by either H/W
• However → attorney’s fees attributable to collecting the amounts in the divorce
settlements due to payee spouse are deductible by the payee spouse.

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Reg 1.263(a)-2(c), 2(e) → Examples of capital expenditures
• No deductions are allowed for:
o Any amounts paid for new building or for permanent improvements or betterments made
to increase the value of any property/estate
o Costs of acquisition, construction, or erection of buildings, machinery, equipment,
furniture, and fixtures and similar property having a useful life beyond the taxable year
o Costs of defending or perfecting title to property
o Architect’s services
o Commissions paid in purchasing securities. Commissions paid in selling securities are
an offset against the selling price, except that in the case of dealers in securities such
commissions may be treated as ordinary and necessary expenses

Problems (p. 460)

(1) S buys 100 shares of Sound Company stock for $3,000, paying her broker a commission of $50 on
the purchase. 14 months later she sells the shares for $4,000 paying a commission of $60 on the sale.

• (a) She would like to treat $110 paid as commissions as §212 expenses. Why?
o (See § 1.263(a)-2(e))
o No, cannot take as an expense deductible under § 212
o On purchase:
 Capitalized  $3,050 is AB
 POINT – NOTHING is deducted as an expense
o What difference does that make?
 If treated as an expense: $1000 gain + $50 § 212 expense (in yr. of purchase) +
60 § 212 deduction in year of sale  $110 deduction = $890 gain. What’s the
big deal?
 Tax on gain vs. Tax on Income:
• Max tax is 15% for gain
• Max tax is 35% for income
 Timing of Recovery Benefit: treated as gain  have to sell to take advantage
 Above the Line: If falls below is a misc. itemized deduction.
• § 62 – not above the line
• § 67 – Not a misc. itemized deduction
o Answer: Costs to buy securities will be added to her basis and the cost to sell will be
deducted from her AR, AR $3940 – AB $3050 = $890 Gain
• (b) What result in (a) above, if instead she sells the shares for $2,500 paying a $45 commission
on the sale
o AR $2,455 (2500 -45) – AB 3050 = 495 loss
o § 62(a)(3)  § 165(c)(2) loss – ABOVE THE LINE
o See also Reg §§ 1.165-9(b); 1.167(g)-1; 1.212-1(h)

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 B. Charges Arising Out of Transactions Entered into For Profit
• How does property have to be used? Production of income § 167
• § 212(1), (2) uses the exact same language, but what about § 165(c)(2) – Transactions entered
into for profit?

WILLIAM C HORRMAN V. COMMISSIONER

TAX CT 1951
• TP received residence by devise in 1940(189 Howard Ave.). TP moved in in 1940 and moved
out in 1942. Sold it in 1945. Net proceeds $20,800. FMV at time he acquired it $60,000(his
basis). FMV at time he left it was $45K—35K to land and 10K to buildings.
• ISSUE #1 can TP take a deduction for depreciation on the property during the taxable years
1943,1944,1945(the years he did not live there)
o CT he is entitled to a depreciation deduction of $500/year if the property was held for
the production of income.--167a2. Use of the property and owner’s intent are the
determining factors. Once he made efforts to rent the property it was being held for the
production of income. Even if not making income and even if the property is offered for
sale. He tried to rent it so he is entitled to depreciate it for the three years at $500/year.
• ISSUE #2 is TP entitled to a deduction for expenses incurred during the taxable years for the
maintenance and conservation of the property?
o §212---held for the production of income—he is entitled to the deductions for years 1943
and 1944.
• ISSUE #3--.Is TP entitled to a deduction for a long-term capital loss from the sale of the property
in 1945?
o The loss must be incurred in any transaction entered into for profit. When property
has been used as a personal residence, in order to convert the transaction into one
entered into for profit the owner must do more than abandon the property and list it for
sale or rent. He would have to remodel or actually enter into a lease, can’t just list it with
a RE agent. TP intended it as a residence immediately. They spent 9K redecorating,
sold their old residence, lived in it for 2 years---there was no conversion here into a
transaction for profit. TP cannot have the capital loss deduction

• Class Notes:
o Held for the production of income, but never rented. Attempts made to rent – INTENT is
important – “Held for the production of income” in expense and depreciate
o 3rd Issue  TP sales property for less, wants § 165(c)(2) loss. TP did not get it here.
 This is an unusual situation, usually you have all 3 or none (depreciation, § 212
deduction, and § 165(c)(2) loss)
o Why did not meet the “transaction entered into for profit” test?
 Lived there
 Must do more than abandon and list for sale (CB p. 463)
 “Unfettered Will” – Must go back and live there?
• WHAT more would you have him do? Somehow give up right to use as
personal residence.
o If rented, would have gotten § 165(c)(2) loss
o POINT of case: Production of income for profit § 165(c)(2)
 If never lived in, probably would be able to take desired issue #3, Gus feels you
should get all 3 or none at all.

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 o Key §§
 Property held for personal use  to rental use  can get deduction, but how do
you calculate the amount? (Similar to part gift/part sale situation)
 When acquired, had $60K FMV -- § 1014 = Basis
 When abandoned for  $45K (Split between $35,000 land and $10,000 house)
 TP then sales for $20K
 What is TP’s AB?
• Value dropped $15K (while held for personal purposes)
• If lived in could sale for loss? No, personal losses not allowed.
 § 1-212  expense while held
 § 1.167(g)-1
• General rule is what basis you had at that time.
• If not rented, then it uses the $45K basis b/c was being used for personal
use.
• What would TP be depreciating? 10K b/c land is not depreciable –
FOCUS ON DEPRECIABLE PROPERTY
• Cannot convert non-deductible personal loss into a deduction
o KEY § -- § 1.165-9(b)
 Not going to convert non-deductible personal loss
 Loss of FMV of property at time of conversion (AB at time of conversion)
 House 20K – 10K; Land 40K  10K
 Analogous that you cannot shift loss from donor to donee
LOWRY V. US
US DIST CT NH 1974
• TPs bring action to recover taxes and interest that they say were erroneously or illegally
assessed, in the amount of $1,072.
• ISSUE: whether the TPs, who ceased to use their summer home as residential property in 1967
and immediately offered it for sale w/out attempting to rent it, converted the property into income
producing property, thereby allowing them to deduct the maintenance expenses incurred after it
was put on the market (he put it on market with higher FMV value)
• TP deducted these expenses because it was held for the production of income. IRS---denied
these deductions because it was a personal residence—no deductions--§262. 1942---TP
acquired the property by gift from is father. Legal title is held by Seven Gates.
• He owned stock in Seven Gates and had a lease for the life of the corporation and on its
termination he would get it in Fee.
• He would have fee simple in TN—Shelley’s rule
• He made no attempts to rent because:
o Easier to sell an empty house
o He would have to furnish the house—didn’t justify renting it
o Rental would be complicated by the corporation’s by laws
• Cash offer in 1973—and sold it
• 1973 tax return showed a net long term gain of $100,536.50
• ISSUE: when and how does residential property become converted into income producing
property?
• HOLDING: the property was held for the production of income and the expenses can be deducted
o Rental requirement is not a litmus test for a conversion from residential to income
producing
• TEST to determine if the Tp’s residence has been converted into a property held for the
production of income: evaluate the TPs intent in light of all the facts and circumstances.
• TP clearly intended to benefit form the appreciated value.
• The TP had a reasonable expectation of profit and the property was held as income producing
• He can deduct the expenses

Class Notes:

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 • Smart guy except he failed to depreciate
• Case has to do with whether property converted to property for use of income

16. Deductions Not Limited to Business or Profit-Seeking

Activities (Chapter 16)
p. 471 – Structural provisions and view as tax subsidies

A. Title
(See York p. 68 for more)
• § 163(a) – did get personal interest deduction until 1986
• § 163(h) – cannot deduct personal interest
o Allows for Deduction of Qualified Residence Interest
 (1) Acquisition indebtedness
 (2) Home Equity Indebtedness
o Method for Acquisition Indebtedness
 (1) Secured
 (2) Qualified Residence
 (3) Under $1,000,000
 (4) For Acquisition
o Method for Home Equity Indebtedness:
 (1) Secured
 (2) Qualified Residence
 (3) Not exceed the FMV (less current acquisition indebtedness)
 (4) Under the $100,000 limit
• Doesn’t matter how you spend it or if single or married for amount
• § 163(d) – Limitation on Investment Interest
• § 67(b)(1) -- § 163  non-miscellaneous itemized deductions (only get if itemizer)
• § 164(b)(5) – Can elect sales tax instead of property tax (have to be itemizer to deduct)

Problems on pg. 498

(3) TPs purchased a home in the current year, which they use as their principal residence. Unless
otherwise stated, they obtain a loan secured by the residence and use the proceeds to acquire the
residence. What portion of the interest paid on such loan may TPs deduct in the flowing situations?

• (a)
o 100% of mortgage deducted
o § 163(h)(2)(D)
o Qualified residence – acquisition indebtedness
• (b)
o 100% of mortgage is deducted
o Still acquisition indebtedness
• (c)
o 100% deducted – Now is home equity indebtedness
• (d)
o § 163(h)(3)(B)(i)(II) – all deductible acquisition (refinancing)
o Enough equity to cover

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 o 500 FMV – 50 AI = 450 Equity; Refinancing = acquisition indebtedness -50K; Enough
equity to cover Home Equity loan of $50K
• (e) Second Residence Issue – DO IN ORDER OF ACQUISITION
o 1st Residence:
 250K AI
 2nd residence = 950K AI  750 only is AI
o Is the 200 under home equity? You can use home equity on the house
o DO NOT LOOK AT OTHER HOUSE  KEEP SEPARATE…the issue is does the 2nd
house have enough equity to cover
o FMV – Debt = Equity --- 1.25 million – 950K loan = 300K equity (we can take all of $200)
o Take $100K  HEI – Deduct interest on 850K??
o Hypo:
 600 FMV
 (400) AI
 (150 HEI)
 = 50 Equity  if you took 50 as HEI, none will qualify, already out of the $1000K
 Take all loans out of FMV to determine equity.
• (f) Grand Father rule
o § 163(h)(3)(D)(i) – If you have bad indebtedness before 10/13/87 – grandfathered in a AI
(NOT ON EXAM)
• Hypo:
o Paid 1.8 Million for home with a 1,080,000 loan  1 million in AI, 80K in HEI  800K in
equity
o House FMV goes up to 2.5 million
 Loan is paid down to 900K – get a new loan for 300K
 Pick up the remaining 20K for HEI

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 17. Capital Gains and Losses (Chapter 21)
• Stakes involved:
o Did not go to 1(h), but Casebook p. 681
o We are assuming 15% and 25% only
o 28% = collectibles
o 25% = did not cover
o 15% = stocks
o If you sold stock for gain, you would, at most pay 15%
o Rule: If you would have been in the 10% or 15% tax bracket, you are only taxed at 5%
and the amount that pushes you over 25% on the tax bracket is taxed at 15%
o If OI takes you to 15% and stock sale takes you to 33%:
 OI is normal
 5% for the amount that takes you up to 25% bracket
 15% for all $ above 25% bracket

§ 1221 – Capital Asset Defined (p. 549)

• (a) has a list of what is not a CA
o The big exceptions are:
 (a)(1) – Inventory
 (a)(2) – Depreciable business/trade property + land
• Real Property = land
• Not talking about all depreciable property, but depreciable property used
in trade or business and land
 (a)(4) – Account’s receivable  sold to third party
• Factoring your receivables
• Discounted, purchaser takes risk
• Keeps (a)(4) and (a)(1) consist
• This is under cash method of accounting
o Clothes, car, food  capital assets
• Issues handled below…what do you do when CA produces G(L)?
o PIE OF ASSETS:
 OI Assets |||| § 1221 CA |||| § 1231 Assets |||| § 1250 Assets (didn’t cover)
• Capital Income  taxed at OI asset rate
• Capital Assets  taxed as OI or Gain
• § 1221 – Capital Asset Defined
• § 1222 – Definitions of Terms (Gains and Losses)
• § 1211 – Limitation on Capital Losses
o Doesn’t matter if ST or LT
o § 1211(b) – Can offset OI by up to $3,000
o If CG – CL = (5,000)  offset OI by $3,000 and ($2,000) is a Net Capital Loss  § 1212

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 o Why the $3,000 loss cap?
 Hypo: LTCG = 10,000 and LTCL = $10,000
• If you sold these in year 1, no taxes to be paid
• But, what if you sold them in two separate years?
o Year 1 – Sold LTCG = NCG of 10K for that year
 If you are in 35% bracket  then taxed at 15%
 $1,500 TI
o Year 2 – Sold LTCL  if no other CG or CL  taken all against
OI  at 35%  $3,500 tax savings
o If sold same year = 0
o If sold separate years (w/o cap) = You make $2,000
• § 1212 – Capital Loss Carrybacks and Carryovers

Problem (p 691)
Here are 2 questions on capital losses incurred in the current year. The figure for TI given in column A
reflects a single TP’s taxable income for each of the two years without regard to his capital gains and
losses. Note that in computing gross income(as adjusted) on the return no gains will be included, since
capital losses exceed capital gains and the §1211 b excess amount will be a reduction

TI LTCG LTCL STCG STCL

Yr 1 10K 2K 6K 2600 1000
Yr 2 10K 2K 10K 2K 4000

For each year separately determine the amount of TP’s capital loss that is allowed as a deduction from
ordinary income under §1211b1 or 2 and the amount and character of his cap loss carryover, if any,
under 1212b.

• Year 1: 10K TI
o 2K LTCG – (6K) LTCL = 4,000 NLTCL
o 2,600 STCG – (1K) STCL = 1,600 NSTCG
o Net these two: ($ 2,400)
o So, you’d wipe out $2,400 of taxable gain
• Year 2: 10K TI
o 2K LTCG – 10K LTCL = (8K) NLTCL
o 2K STCG – 4K STCL = (10K) STCL
o Net these two  ($10,000) NCL
o Can offset $3,000 of OI
o Will the remaining $7,000 NCL (§1212(b)) be long-germ capital loss?
 Asking, where did the 3,000 offset come from?
• NSTCL (b/c STCL offset STCG which is taxed at OI rate)
o You can have a little bit of both reduced by offset. If your NLTCL = 6K and your NSTCL
= 4K, you offset TI by 3K (reduce NSTCL  1K) So, 1K NSTCL and 6K LTCL  Carried
over to next year

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 B. § 1231 Recharacterization
§ 1231 – Property Used in the Trade or Business and Involuntary Conversions
• NCG = preferential treatment
• You prefer capital gains and ordinary losses
• This section came to us after WWII ship sunk and they weren’t able to recover
• This is a pro-tax payer provision (best of both worlds treatment)
• Main Hotchpot Provision
o (a)(1) – If § 1231 Gs > § 1231 Ls  LTCG or LTCL
 Net of these two = positive
o (a)(2) – If § 1231 Gs =< § 1231 LS  Ordinary Income (loss)
• What is a § 1231 Asset:
o (1) p. 549 -- § 1221(a) – Everything, but this list
 § 1221(a)(2)
• Property not capital asset
• § 167(f) intangibles
• § 168 Depreciable tangible
• § 179 Bonus depreciation
• § 197 Intangible amortization
• Land
o (2) § 1321(a)(3) – Definition
 Difference from § 1221(a)(2) – HELD FOR ONE YEAR.
• Most business assets are § 1231
• Inventory are not  OI
o (3) § 1231(a)(3)(A)(i) – trade or business, etc.  § 1231(b)
o (4) § 1231(a)(3)(A)(ii) – Involuntary or compulsory conversion
 Must be in a trade or business
• How can you have a gain with fire?
o Insurance payments
• See the flush language under § 1231(b)(4)(C)  O.I.  B/c ordinary assets when thrown out of §
1231 (this is good)
• If Subhotchpot G>L, you don’t want that to be OI

Problems p 748
(1) Hotchpot engaged in (or encountered) the following transactions(or events) in the current year.
Determine separately for each part how the matters indicated will be characterzed for the current year,

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assuming in all parts other than g-I that §1231c is inapplicable. Ultimate goal  Characterization of
Gain or Loss as Ordinary or Capital

• (a) Hotchpot sells some land used in his business for four years for $20K. It had cost him $10K.
He also receives $16K when the state condemns some other land that he had purchased for the
$18K three years ago which he has leased to a third person.
o 10K gain on land (§ 1231)  LTCG
o 2K loss on condemned property
 Is it §1231? Yes. § 1231(a)(3)(A)(ii)(II)  LTCL

• (c) Hotchpot sells a building used for several years in his business, which he depreciated under
the straight line method. The sale is $15K and the adjusted basis $5K. His two year old car,
used exclusively in business, is totally destroyed in a fire. The car had a $6K AB but was worth
$8K prior to the fire. He received $4K in insurance proceeds.
o 10K G on building (main hotchpot  LTCG)
o 2K (L) on car (sub-hotchpot  OI)

• (d) In addition to the building and the car in (c) assume that Hotchpot had a painting that he had
purchased 2 years ago which was held in connection with his business and which was also
destroyed in the fire. The painting had been purchased for $4K and he received $8K in insurance
proceeds.
o 10K on building  main hotchpot  LTCG
o 2K L on car and 4K G on painting  sub-hotchpot  back to main hotchpot b/c L < G 
2K LTCL

• (g) What result under the facts of (d)(building gain, car loss, and painting gain), if four years
before the fire Hotchpot had had a $5K net §12231 loss and three years before a $3K net § 1231
loss, and he had no other §1231 transactions in other years.
o §1231(c)
 5 most recent years
 Add +3 (L) + 5(L) = 8K (L)
 10K (L)
 14K G
 8K OI
 4K LTCG

C. § 1245
Recapture of Depreciation on the Sale of Depreciable Real Property
• 100K asset purchased, took depreciation of 40K = 60K AB
• You sell asset for $75K for a 35K Gain, so you really only had $25K in depreciation
• $60 offset your income, so if in business or trade, then § 1231
• Gain on sale of depreciable asset to the extent of depreciation that you took, will be treated as
ordinary income. All would be ordinary income (all $35 would be)
o Has to be sold @ gain. If sold at loss, if § 1231 asset, then = § 1231 loss (i.e., if you sold
for $30 instead of $75)
• What if you sold it for $115 ($75 of Gain)?
o Only $60K should be treated as OI, other $15  § 1231 asset than § 1231 gain
o How could this be depreciable and not § 1231? For production of income  NOT in §
1221(a) exception, so capital asset.

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