Federal Income TAX I.

Intro
A. Basic Computation of Tax Liability and Definitions
1. Gross Income (GI), 61: All income from whatever source derived 2. () Above-the-Line Deductions: Subtracted from GI to arrive at 3. Adjusted Gross Income (AGI): Amt remaining from GI after aboveline deductions 4. () Below-the-Line Deductions: Subtract from AGI the sum of personal exemptions (151 & 152), + the greater of: a. Standard Deduction (63); OR b. Itemized Deductions (67) 5. Taxable Income (TI): Amt remaining after below-line deductions a. Personal Consumption + Changes in Net Worth (Haig-Simons) 6. Tentative Tax Liability = TI x Tax Rate 7. () Tax Credits = Final tax liability a. Reduce taxes dollar for dollar b. Non-Refundable v. Refundable i. Worthless if you have no tax liability and non-refundable ii. If refundable and you have no tax liability, you could get $ from IRS

B. Marginal v. Average Tax Rate

1. Marginal Tax Rate (MTR): Rate at which next taxable dollar will be taxed a. As long as MTR is <100%, its worth it to earn more $ b. Useful for planning incremental income c. Influence value of exclusions and above-line deductions, but not tax credits 2. Average Tax Rate (ATR) = Total Tax Liability/TI

II. Tax Policy & Provisions

A. Taxation
1. Process by which govt transfers cash/resource from private sector to public/private 2. 3 main purposes: a. Raise Revenue: to finance public services b. Redistribute: from rich to poor c. Correct Market Failures that are caused by Externalities: i. Positive: When A acts to Bs benefit w/out benefit to A ii. Negative: When A acts to Bs harm iii. Create tax incentives to encourage positive externalities and penalties for negative externalities

B. Considerations
1. Incidents of Tax (who bears burden) 2. 3 Traditional Tax Policy Goals a. Equity: Varies depending on moral and philosophical views i. Vertical: Those w/ greater ability to pay should pay more taxes A. Characteristics 1. Progressive: Higher % for higher income 2. Proportionate: Everyone pays same % 3. Regressive: Higher income pay smaller % of their income B. Theories of Distributive Justice (in choosing characteristic) 1. Utilitarianism: Goal is to maximize sum of all utility (satisfaction from circumstances) for everyone a. Due to Declining Marginal Utility of Income (the more $ you have, the less utility each additional $ is worth), we should spend taxes on ppl progressively b. Problems i. Doesnt outlaw behavior if it gives more utility ii. Disincentive to work harder iii. Only looks at aggregate utility and confiscates wealth from individual, and doesnt recognize individual property and civil rights iv. Utility isnt objectively measureable 2. Liberalism: Make meeting to design society before knowing your status in it (Veil of Ignorance) a. Maximin Principle: Make decisions to your benefit, assuming the worst position in society (i.e., poorest) b. Problems i. Incentive for poor not to work ii. Assumption that veil of ignorance leads to ppl to assume theyll be in worst situation (i.e., that ppl would be so risk-averse) 3. Libertarianism: Only individuals earn income and govt cant take away their property w/out consent a. Problem: Ppl may obtain property by unequal opportunity ii. Horizontal: Tax similarly situated ppl equally (e.g., tax differently based on source of income, intended use of income, liquidity of income, family structure) b. Efficiency (Neutrality) i. Tax should minimally interfere with economy and behavior, except to fix market deficiencies ii. We should tax activities that are inelastic and wont alter behavior

A. Elasticity: When behavior/activity is taxed and response varies c. Simplicity (minimizing administrative and compliance costs): 3 kinds: i. Compliance: now least costly due to Turbo Tax ii. Transactional: When taxpayers look for ways to structure transaction to reduce tax iii. Rule: To be able to figure out what tax rule is

C. Tax Base (for income taxes)

1. Tax based on ability to pay 2. 3 theories of criteria to consider in determining ability to pay: a. Earning Ability: hard to measure b. Taxable Income: this is what we use c. Consumption Tax: based on how much you consume/spend i. Value Added Tax (VAT): tax collected at certain levels of production ii. Sales Tax: levied on customers iii. Always regressive since poor spend more of their income, so % income is higher A. But could provide deductions for food, home

D. Tax Expenditures
1. Revenue losses attributable to tax laws which allow special exclusion, exemption, or deduction from GI or which provide special credit, preferential tax rate, or deferral of tax liability 2. 4 purposes of tax benefit: a. Accurately measure income (e.g., bus. expenses are deductible) b. Administrability concerns c. Measure ability to pay d. Incentives or subsidies for socially desired activities/investments 3. No economic diff. bet tax benefit or govt giving you $ (direct spending) a. Arguments for Direct Spending i. Not everyone pays taxes and thus, wont benefit from Tax Benefit, assuming Benefit isnt refundable ii. Taxpayer may not understand Benefit and amt, and thus misunderstand intended incentive, i.e., more transparency/visibility as to what govt is trying to do iii. More simplicity and less tax code (Benefit is harder to remove from Code bec infrequently under review) b. Arguments for Tax Benefit i. Ease of administration (favored by Conservatives bec. need less depts. and less govt control) ii. Less stigmatizing (no need to go to Welfare office) 4. Surrey v. Bittker

a. Surrey: Tax should be open and non-discrete, such as having tax budget i. Tax expenditures are more valuable to rich ppl ii. Dislikes hidden special tax breaks iii. Solutions: A. Repeal all tax expenditures B. Be aware of all expenditures b. Bittker: Criticized unclarity of income tax base

E. Sources of Tax Law

1. The Code: Power to tax given in Const. (Art. 1, 8; 16th Am) gives broad authority to effectually tax anything 2. Legislative History: Reports by committees, hearings, debates, Blue Book a. Assist in shedding light on what was intended in Code b. Conference Report: Report by both Houses to explain both of their versions c. Blue Book: Report by Joint Committee on Taxation, which serves both Houses and is non-partisan d. Ultimate goal of process is congressional intent 3. Administrative Interpretations a. Treasury Regulations: Meant to interpret Code w/ force of law that IRS must follow i. Legislative v. Interpretive ii. Temporary: Binding temporarily iii. Final: Binding even retroactively iv. Proposed: Helpful, but not binding b. IRS Guidance i. Published: Can be relied on to some extent A. Revenue Rulings, Revenue Procedures, and Notices B. Taxpayers have no standing for suit for tax cut for other taxpayers ii. Unpublished: Not binding, but relied on in practice A. Private letter rulings, TAM, FSA, GCM, CCA 4. Judicial Interpretations a. Tax Ct, Ct of Claims, Dist Ct i. In Ct of Claims and Dist Ct, you must 1st pay requested amt, then file for refund ii. In Tax Ct, you dont have to pay 1st, but no jury trial b. Appeal goes to App Ct from Ct of Claims

F. Special Interest Provisions in Code

1. Exist bec insignificant effect on rest of us, but significant effect and effort on behalf of special interests 2. Many are hidden in Code

a. Ear Mark Rules: Congressmen must disclose provisions they vote for and identify beneficiary i. Congressmen consent to this bec of Precommittment and goal of transparency (but no cost of violating precommittment since no enforcement by other branches of govt) ii. If not complied w/, Code could nullify special interest provision b. Reconciliation Process 3. Horizontally Inequitable since poor ppl cant afford lobbyists a. Could argue that these provisions trickle down and benefit everyone b. Could argue that Congressmen are merely representing constituents

III. What is Income

A. Economic/Conceptual Ideas of Defining Income
1. The Code: taxes Net Income (NI), not GI a. 61: GI is all income derived from whatever source derived i. Income in form of compensation (services, $, and property [T.Reg 1.61-2(d)(1)] is valued at FMV b. 71-90: Inclusions c. 101-130: Exclusions and Deductions (e.g., bus expenses/cost of earning income) i. Maybe Horizontal Inequity since more deductions for ppl w/ same income but bigger bus expenses ii. But overall, narrow definition of deductions creates simplicity, efficiency, and equity 2. Haig-Simons TI: Personal Consumption + Changes in Net Worth or Savings (focuses on consumption, not source of income) 3. Case Law (source perspective) a. Old Law (Eisner v. Macomber): Gain derived from capital, labor, or both b. New Law (Glenshaw Glass): Net accretions to wealth over which taxpayer has complete dominion and control i. Income = NI from Labor + NI from Capital + Windfall Gains (unexpected gains, e.g., prize $, punitive damages) 4. Posner: All pecuniary and non-pecuniary receipts, including not only leisure and other non-pecuniary income from household production, but also gifts, bequests, and prizes a. Could tax leisure time b. Difficult to administer c. Treads on liberty and forces ppl to work

B. Form of Reciept; Compensation for Services

1. Form of receipt of income is irrelevant and FMV is income and part of compensation package, even if not in $ 2. Tax on Tax: Income tax that is paid for by 3rd party (e.g., employer) as compensation for services is taxable income (Old Colony Trust v. Comr) a. Rationale is that not having to pay expense is income i. Economic Substance Doctrine: Although tax paid by 3rd party is given to IRS, its effectively given to taxpayer b. Avoids horizontal inequity of 2 ppl who earn same salary, but only one of their employers pay their tax i. But doesnt create equal treatment for employee who pays own tax, since employee whose employer pays tax will still have higher after-tax income due to employer paying tax on tax also ii. Grossing Up (getting pre-tax income) A. Ya = After tax income; YP = Pre tax income; T = tax rate

B. Ya = YP (YP x T) C. Ya = YP (1T) D. YP = Ya / (1T) c. Current Law: Employer must pay tax on tax on taxuntil tax is 0 (Old Colony is no longer good law in regards to only paying tax on tax paid) 3. Property Transferred for Services; 83 a. If taxpayer gets property for services, excess of FMV over what he paid for property isnt GI until theres no substantial risk of forfeiture (a) i. FMV determined at time when theres no risk of forfeiture, not at time of transfer ii. Substantial Risk of Forfeiture (c)(1): Defined as rights being conditioned upon future services b. Could elect to include excess in year of transfer (b) i. If election is made, (a) doesnt apply so no TI when no longer subject to risk of forfeiture ii. Cant deduct loss if he subsequently forfeits property or FMV iii. Good to do when he thinks FMV , so pay tax on excess now, which is smaller than it will be later A. Even if FMV stays same, still smart bec of time value of $ (i.e., tax deferral); See Appendix, p. 839 for PV and FV tables

C. Fringe Benefits
1. General: Benefits transferred to employee by employer that fall between benefitting employer and personally benefitting employee 2. 119 (codified Benaglia) a. Meals and lodging are excludable for employees and spouse/dependent when: i. At convenience of employer ii. Meals are furnished at premises of employer iii. Lodging is condition of employment b. If conditions not met, employee has TI effectively gives it as gift to spouse or dependent c. Only excludes from income a transfer in kind thats furnished, not $ or reimbursement d. Must distinguish bet compensatory motive (TI) and convenience for employer (not TI) (Benaglia v. Comr; Where employer paid for hotel suite and meals for hotel manager and his wife) i. Under Benaglia, these benefits are valued at 0 since concluded to be fully for convenience of employer and no personal benefit for employee A. Cost to employer is irrelevant as to benefit of employee

B. Cost of Alternative Means (amt needed to pay for benefit on your own) is too speculative C. Easier administrability ii. Under Haig-Simons, could argue horizontal and vertical inequity since this employee gets more benefits and value than others who get same salary (but have to pay tax on salary) and other lower income earners cant get same benefit A. Could argue no inequity since employee not actually getting personal benefit, rather employer benefits 3. 132(a): Lists other Fringe Benefits a. (1) Any subject matter dealt with in another section cant be included in 132 i. Except for De Minimis fringe (e) and Moving Expense reimbursement (g) b. Capitalization: Since fringe benefits are excludable, employers ca pay less salary and more in benefits since cheaper for employer and better for employee after-tax wise i. Incidents of exclusion of benefits fall on employer, who can now capitalize exclusion into salary c. Discrimination, 132(j): Fringe benefit cant discriminate bet high and low compensated employees and must be available to all on substantially same terms i. Otherwise, entire FMV of benefit is GI 4. Travel Expense: Usually, when dominant purpose of trip from payors perspective is bus, its excludable (US v. Gotcher; Where ct ruled payment for Ps trip to Germany to see VW facilities in order to induce his investment was excludable) a. Cts will consider several factors: i. Whether trip is for benefit of payor ii. Whether theres legitimate bus purpose and no significant time spent for pleasure (i.e., no personal value or that its <FMV) iii. How much control taxpayer has over scheduling (if too much control, ct will consider that portion of trip to be pleasure) b. Rationale: Gotcher compared travel expenses to 119 (meal sand lodging), which allows exclusion if benefit is primarily for employer i. Taxing these trips would be difficult since FMV of pleasure value is subjective (but could determine certain set % that is excludable) c. Cant be Fringe benefit since referring to when taxpayer isnt employee of payor d. Spouse Travel Expenses i. 274(m)(3): Spouses travel expense isnt deductible as bus expense for employer unless shes employee or bus purpose ii. Reg 1.132-5(t): Allows exclusion for spouse as working condition fringe benefit if theres legitimate bus purpose

e. Problems (w/ Gotcher): i. Inequitable: Only benefits high-end employees ii. Inefficient: Encourages more bus trips than needed 5. Employer-Provided Health Insurance (105 & 106) a. 106: Premiums of employer-provided health insurance are excluded from employees income (No Max.) b. 105: Benefits paid from employer-provided health insurance are excluded from employees income c. Problems: Inequitable to self-employed who dont get this benefit

D. Imputed Income
1. General: No tax when ppl use their own $, property, or services tot heir own or familys benefit 2. Problems w/ Not Taxing Imputed Income: a. Inequitable treatment for 2 ppl who make same salary, but one works more (and taxed on extra income) and pays for service, while the other doesnt work more and performs services himself i. But cant create deduction for paying for these services bec tax base would be obliterated b. Less tax revenue c. Inefficient decisions i. E.g., If A can work for 50k, taxed at 30% (after tax is 35K), but pays housekeeper 35k, hes at best indifferent to working and paying housekeeper or staying home and performing services himself (maybe incentive to stay home so he could do 35k worth of work and benefit form all of it) ii. This is inefficient since society values As work at 50k, but housekeeping only at 35k iii. Also, unfairly encourages women to stay home 3. Administrability Problems w/ Taxing Imputed Income: a. Valuation issues b. Political issues of privacy c. Which services/activities should be taxed?

E. Gifts & Bequests

1. 102 a. Gifts and bequests are excludable from GI, and not deductible to donor (a) i. To determine if theres gift, look to mainsprings of human conduct to see if payors motivation was detached and disinterested generosity (Comr v. Duberstein) b. Income from gift (property) isnt excludable (b) c. Any gift from employer employee isnt excludable (c) i. So employee has income under 61, but employer has bus deduction under 162

2.

3.

4. 5.

Proposed Reg; 1.102-1(f)(2): Exception to 102(c), providing exclusion of gifts in case of extraordinary transfers to natural beings of employers bounty (i.e., anyone who typically would inherit estate from decedent) if not made in recognition of employees employment A. I.e., transfer could be gift if proven to be unrelated to employment (e.g., father son) iii. Prof; Symmetrical Treatment: Alternative to 102(c) could be to allow parties to agree that if its income for recipient, then its deductible for payor, or visa versa A. Problem: This would allow too much flexibility to alow arrangement to pay lowest taxes (i.e., shift tax liability to lowest bracket) 274(b): No deduction for payor under 162 or 212 for gift to bus associate > $25 (i.e., gift to bus associate is only deductible as bus expense up to $25) a. Gift defined as anything excludable under 102(a) and that meets Duberstein test b. Recipient still has no income for entire gift (even portion > $25) c. Limits flexibility of bus associates as to how much is labeled as bus gift to qualify as bus expense i. So payor may just not label as gift in order to take full deduction as bus expense, and in which case, recipient has income ii. Cts dont care about labels given to transaction, rather will look to true motivations and whether transfer is actually compensation for services Prizes & Awards; 74(a): Included in GI a. Regs: Defines them as door prizes (TV shows) b. Include FMV of goods in GI i. Could argue list price or resale price if you sell it c. Rationale: Not gift bec not really gratuitous, rather its compensation for some service (e.g., being good audience) and donor benefits in some way (e.g., publicity and marketing) Tips; Reg 1.61-2(a): Included in GI a. Exorbitant tip could be argued to be gift Gift Tax v. Estate Tax a. Gift Tax: Tax on donor for gifts > 12k/donee/annum b. Estate Tax: Tax on estate after $3m

ii.

F. Scholarships & Fellowships

1. 117: Exclusion is limited to qualified tuition and related expense (e.g., books) 2. No exclusion for room and board

3. Any portion received for teaching, research, or other services that are required as condition for receiving scholarship is not excludable (c) (i.e., Quid Pro Quo, e.g., athletic scholarship)

G. Intro to Basis Recovery

1. Statutes a. 61(a)(3): GI includes gains derived from property b. 1001(a): Defines computation for gain/loss i. Gain = Amount Realized Adjusted Basis ii. Loss = Adjusted Basis Amount Realized c. 1001(c): Amt Realized = $ Received + FMV of Property received d. 1011: Basis is defined in 1012 and adjusted per 1016 e. 1012: Basis is generally cost of property 2. Function of Basis: To determine income for accounting purposes on taxable gain from sale a. We only tax gain bec we dont want to tax after-tax $ used to buy asset (double tax) 3. Complications: Basis gets adjusted (e.g., invest after-tax $ in asset) and (e.g., depreciation deductions) 4. Different Methods of Basis Recovery a. Expensing: Deduct cost at outset when purchased; Immediate Basis Recovery i. Basis doesnt reflect cost bec Basis is 0 ii. When sold, ALL $ and property received is taxable income/gain b. Capitalizing: Dont deduct cost at outset, rather capitalize cost into Basis i. Basis reflects cost and recovered when sold ii. When sold, compute gain/loss based on cost c. Depreciation Deductions: Dont deduct cost at outset (so Basis relfects cost), rather reduce Basis over time to reflect depreciation of asset i. Also called Capitalizing a Depreciable Asset 5. Considerations of Which Method is Preferable a. Consider how much income you have this yr and bracket, as compared to projected income/bracket in future years (want to shift deductions to higher bracket and income to lower bracket) b. Present Value of $: Want to reduce TI sooner than later (so Expensing would be best and Capitalizing would be worst) 6. Dividends: Cannot recover basis of stock in dividends, rather can only Recover Basis Last when stock is sold a. E.g., A buys stock for $100 in Yr 1, gets $15 dividend in Yr 2, and sells for $175 in Yr 3 i. A has GI of 15 in Yr 2, and 75 (175-100) in Yr 3

A cant claim 0 GI in Yr 2 and 90 (175-85) in Yr 3 by arguing that the $100 Basis is reduced by the dividend since it comes out of RE (i.e., Recover Basis 1st) A. This would be advantageous bec of PV of $ 7. Sale of Gifts; 1015(a) a. Gains: To compute gains on sale of asset received by gift, use Carryover or Transferred Basis (i.e., Donors Basis) i. This is instead of having donor pay tax on appreciation of asset upon giving gift ii. Easier to assess FMV when sold b. Loss: To compute loss on sale of gift, Basis is lower of Donors Basis or FMV at time of gift (i.e., use FMV when donors basis > FMV) i. Done to prevent shift of loss to higher bracket ii. Donor could avoid this by selling it himself and benefit from full loss by using his basis, and then giving $ to donee c. Doesnt apply to gifts of cash (i.e., when gift of cash is used to buy asset, Basis is cost) d. Arguably inefficient bec encourages donee to hold property to avoid tax on carryover gain 8. Sale of Bequests; 1014 a. Stepped-Up Basis: Basis for bequeathed property is FMV at time of bequest i. Appreciated/Depreciated value (gain/loss) while in decedents possession is lost (not accounted for) ii. Could result in Stepped-Down Basis if value from when it was purchased to when its bequeathed A. Testator could avoid losing deduction from loss by selling depreciated property, recognizing loss deduction, and then bequeathing $ instead b. Does not apply to bequest of cash (i.e., asset bought with bequeathed $ takes Basis of cost)

ii.

H. Allocation of Basis (i.e., when Basis is recovered)

1. Rents a. 167(c)(2) (and under 61(a)(3) and 1001): No portion of Adjusted Basis shall be allocated to leasehold interest, i.e., Basis cant be used to offset rents (i.e., cant recover Basis from rents) since gain isnt realized until property is sold i. Cts distinguish bet losses of fruit (income, rent) v. loss of tree (asset itself, building) (Hort v. Comr) A. When theres loss of rental payments from property (e.g., settlement of cancellation of lease), theres no value of the asset itself, so no Basis (capital) recovery to offset income (i.e., substitute for rent is not return of capital) B. Depreciation deductions should compensate

1. But this doesnt help if value of building decreases immensely (e.g., the Great Depression) C. Prof: But this distinction fails to consider that PV of asset/building takes into account PV of stream of income/rents b. Haig-Simons: enforces Mark-to-Market, so any increase/decrease in value of property is income/loss i. Administrability problems (how to value when no sale) ii. Liquidity problem since no resource to pay tax from 2. When Portion of Land is Sold (e.g., easement or certain rights to property in perpetuity) a. Reg 1.61-6(a): Allocate Basis in proportion to FMV of each portion of property at time of original purchase i. E.g., M buys 400 acres for $200k. She then sells hunting rights in perpetuity for $80k, when the land is worth $400k. ii. Assuming FMV of easement (hunting rights) is 20% of entire land, Basis of easement is 20% of $200k = $40k, which reduces Basis of entire land to $160k (200-40). iii. Gain is 80k (amt realized) 40k (basis recovery) = 40k iv. 400k value of land now is irrelevant; Only care about FMV at time of purchase of land b. Reg 1.61-8(6): When initial allocation of FMV of portions cant be determined, simply offset income entirely by that amt of Basis, and deduct total Basis by that amt (amt realized)

I. The Realization Requirement

1. General; 1001(a): Appreciation in value of property isnt taxed until sold or exchanged, i.e., theres a realization event a. Justifications for not using Mark-to Market i. Valuation: too difficult to determine value annually ii. Liquidity: no resource/cash to pay from b. Haig-Simons: Theres TI when value appreciates bec its increase in wealth/economic power 2. Treasure Trove/Windfall a. Reg 1.61-14: Treasure trove/windfall is income b. Although 74 includes prizes and awards, which seems to exclude treasure trove, 61 includes EVERYTHING in income unless specifically excluded (Cesarini v. US) c. Tax is assessed in year $ is found, not in yr of purchase of item in which $ was found d. Miscellaneous: Although some items should be treasure trove under Regs, IRS has declared them not i. Fisherman Catching Rare Fish: Not treasure trove, so not GI ii. Catching McQwires HR Ball: Not treasure trove, so not GI

These are possibly distinguished from treasure trove bec theres invested capital/labor, so no tax till sold bec simply a benefit of bargain purchase 3. Taking a Deduction as a Realization Event a. Theres realization event when taxpayer shows intent to exercise complete dominion over asset, which is demonstrated by using them in way to take a deduction (Haverly v. US) i. E.g., Principal who accepts unsolicited sample textbooks and then donates to charity and takes deduction, now has income for value of books (Haverly) ii. Simply possessing the asset (books) isnt equal to their FMV and may only have bus, not personal value b. The receipt of the asset is monetized when used as a deduction (Cash Benefit), thus creating a resource from which to pay tax 4. Stock Dividend a. Rule: Its unconstitutional under 16th Am to tax stock dividend (Eisner v. Macomber) i. Prof: Seems to imply theres only realization event when theres cash or opportunity to convert to cash b. Rationale: Theres no economic increase in wealth bec total value of shares is same. Its more like RE. Its not derived/received from capital (GI is gain from capital, labor, or both), rather if anything, is mere increase in value c. Criticism/Haig-Simons: Theres still accretion in wealth bec RE is being distributed to SH, so theres realization event when corp makes RE, i.e., should be treated same as cash dividend (Mark-to Market) i. Pros and Cons to Using Mark-to Market A. Pros 1. Horizontal Equity among those who own property that earns cash (e.g., cash dividends) and those who own property whose value , but no cash (e.g., stock dividend). This prevents possibly inefficient incentive to buy stocks whose value as opposed to those that give cash dividends 2. Prevents Lock-in Effect of Realization since ppl wont feel need to hold on to stock to avoid tax on sale B. Cons: Liquidity and Valuation issues (e.g., Close Corp) 1. But could just require sale/exchange when these problems arise 5. Disposition/Exchange of Property a. 1001(a): There must be a sale or disposition of property in order to constitute a realized gain/loss b. Reg 1.001-1: Disposition is defined as the exchange of materially different properties

iii.

i. ii.

iii.

iv.

A change in legal form, i.e., legal entitlement, is enough (Cottage Savings v. Comr) E.g., When 2 companies exchange equal valued pools of loans which have materially different underlying properties/assets and borrowers (i.e., security and borrowers), theres disposition, even though the risk allocation is the same, since theres a change in legal entitlement (Cottage Savings) At Odds w/ Eisner: Cottage Savings seems to conflict w/ Eisner since in Eisner, ct focuses on economic perspective that P didnt realize gain bec no change in economic value from stock dividend, although there was change in legal entitlement. Here, ct is arguing exact opposite. Haig-Simons: There should be no income/loss bec no change I net worth since loans had same value

J. Annuities & Life Insurance

Annuities a. Definition: K of specified amt of $ paid at intervals, often for life i. Also includes Insurance K where theres large lump sum payment at some point of future b. 72 i. Annuity is income (a) ii. Exclude from income the recovery amt, based on Exclusion Ratio (b)(1) A. Exclusion Ratio = Investment/Total Stated Return B. This accounts for recovery of Basis (i.e., of investment) C. So PV of tax liability is lower than savings acct w/ same interest and payments D. E.g., O has 2 options. Option 1 is to buy an annuity for $7k, which will pay $1k/yr for 10 yrs. Option 2 is to deposit 7k in a savings acct, which would allow him to withdraw 1k/yr for 10 yrs. 1. The annuity is better since for the savings acct, O is taxed on interest each year, which is higher in the earlier years and over the yrs bec the balance on which its computed . However, on the annuity, applying an exclusion ratio of 7k/10k = 70%, O only pays tax on 300/yr (70% of 1k is excluded), which is less than tax on interest of savings acct in earlier yrs, so PV of tax liability is lower for annuity. iii. Life Annuity: Exclusion ratio is based on life expectancy (i.e., total return amt she would get based on life expectancy) A. Mortality Gain: if person lives longer than expectancy B. Mortality Loss: if person lives less than expectancy iv. Rationale: Liquidity and Administrability 2. Life Insurance 1.

a. 101: Entire payment from life insurance proceeds is excluded if paid by reason of death of insured i. No tax on mortality gains/losses ii. Beneficiaries dont pay tax on proceeds (neither does insured) b. The Basics i. 2 components of Life Insurance A. Insurance Element: referred to as Term Element 1. Protects beneficiaries in case policy holder dies prematurely 2. Pure Term: Pay certain amt of $ and Insurance Co pays beneficiaries if you die w/in certain period of time; No Savings element B. Savings Element: You pay certain amt and Insurance pays whenever you die 1. Extra amt that you pay more than you would under Pure Term is savings bec Insurance puts that $ into savings in order to fund benefits for another yr that you live c. Modified Endowment K; 72(e) [DONT WORRY ABOUT IT]: funded more rapidly; Savings ratio is higher than needed to fund benefits i. Distribution that exceeds investment will be taxed ii. If its cashed out early (before age 59), 10% penalty d. Advantages of Insurance Over Stepped-Up Basis from Bequest i. Life Insurance Co can shift around investment portfolio of savings element w/out triggering taxable gain ii. Life Insurance Co can also invest in assets producing current income w/out policyholder paying tax on income iii. Can cash out life insurance K before death and get significant tax advantages iv. To take full advantage of stepped-up Basis under 1014, must buy investment that doesnt produce current income (e.g., interest and dividends, which would be taxable now to Testator), and cant sell them until death w/out tax consequence, even if you want to trade for different investment 3. Tax Policy Reasons for Favoring Insurance & Annuities a. Encourages savings b. Avoids investment risk c. Avoids mortality risk 4. Problems w/ Favoring Insurance & Annuities a. Inefficiency: maybe could get better investment elsewhere b. Horizontal Inequity: Those who invest in Life Insurance get benefit that others dont

c. Vertical Inequity: Higher income ppl get more benefit bec higher marginal rate, so saving more. Also, poorer ppl cant afford these investments 5. Annuity v. Insurance: Although it may be true that if you expect to exceed life expectancy, its more profitable to get Life Annuity bec youll get more payments, a high marginal tax rate make Insurance better bec proceeds arent taxed

K. Borrowed Funds
1. General: Borrowed funds are not income, whether used for bus pr personal purpose a. No statute b. Rationale: No increase to wealth since liabilities rise as much as assets i. Benefit from time value of $ balanced w/ interest on loan c. Lender cant deduct principal of loan for same reason d. Repayment of loan isnt deductible e. Must be consensual recognition, express or implied, of an obligation to repay (Collins v. Comr) 2. Illegal Income: Not excludable as loan if no mutual understanding of obligation to repay (Collins; Where Ct ruled P had income for full amt that he bought betting tix on credit from employer and lost of it) a. Deduction under 165(c) for Restitution payment (Collins) b. Gambling loss deduction under 165(d) limited to gambling gains c. Rationale: i. Horizontal Equity among legitimate income earners who have to pay taxes on earnings ii. Helps catch criminals (Al Capone) d. Problems i. Valuation: Could argue that value of stolen tix isnt equal to that amount in $ ii. Allows fed govt to interfere w/ state/local jurisdiction of criminal law iii. Punishes criminals twice iv. Adversely affects victim since IRS has preference over creditors v. No increase in wealth bec liability to pay it back 3. Discharge of Indebtedness a. Cancellation of indebtedness is income i. Tax Benefit Theory: Borrower is richer by amt cancelled bec doesnt have to pay back that amt received in loan, i.e., account for benefit of asset bec asset no longer has offsetting liability ii. Insolvency; 108(a)(1)(A)-(B): Cancellation is not income if youre insolvent (liabilities > assets)

A. Tax attributes must be reduced (i.e., Basis in asset received must be reduced) B. Exclusion limited to amt of insolvency C. Justified bec cant pay back anyways so no liability discharged, and we want businesses to rebound b. Reduction in Purchase Price (108(e)(5): is not income i. Debt of purchaser to seller is reduced ii. Basis is reduced by reduction iii. Diff treatment for family, partnership, and corp c. Disputed Amount: When amt of debt is disputed and then settled, there is no income because theres no cancellation of debt, rather its paid in full according to amt agreed upon (Zarin v. Comr) i. Settlement of Gambling Debt: Zarin applied this theory to gambler who gambled on credit, lost most of $, and settled w/ casino for much less A. Tax Ct held this was discharge of indebtedness and that dispute was only in regards to enforceability of debt, not amt B. Haig-Simons: Could argue compulsive gambler gets no utility out of credit and actually detrimental C. Valuation Problem 1. Gambling chips are received from seller of service and are not $ (so issue if D is really wealthier) 2. Also, maybe debt is never worth as much as stated amt bec casino never expects to collect full amt, especially not from compulsive gambler and bec of no legal enforcement ii. Zarin is diff from Collins since in Zarin, casino knew what it was agreeing to

L. Effect of Debt on Basis & Amount Realized

1. Recourse v. Non-Recourse Debt; General a. Recourse Debt: Borrower is personally liable and may or may not be secured against collateral asset, so lender could collect from any of borrowers assets i. Included in Basis (- depreciation) upon sale of collateral ii. Assumed debt is included in Amt realized upon sale of collateral A. For RD > FMV, any debt discharged in excess of FMV is treated as cancellation of indebtedness, which avoids conversion benefit since taxed as ordinary income (Reg. 1.1001-(2)(a)(a) & Ex. 8) b. Non-Recourse Debt (NRD): Borrower isnt personally liable and is secured by collateral asset (e.g., mortgage), so lender can only collect from collateral

If collaterals FMV < loan, borrower will default and let lender foreclose and take loss on it A. But as equity (i.e., FMV Subjected Debt) from payments to lender, borrower will be more inclined to pay off loan and not default 2. Effect of NRD on Amount Realized & Basis; Tax Shelters a. Amount Realized includes NRD assumed + $ received in sale of collateral (Crane v. Comr) i. There is economic benefit to assumption of NRD when FMV > or = Debt since borrower doesnt want to foreclose and wont default ii. Entire NRD assumed is included in Amt Realized, even when it NRD > FMV at time of sale (Comr v. Tufts) A. Even though no economic benefit to borrower (since not compelled to avoid default when debt > FMV), theres tax benefit by full amt of debt being included in Basis to calculate higher depreciation deductions w/out equity/liability (so this recaptures depreciation deductions in Amt Realized and increasing gain from sale) B. Conversion Benefit: Borrower still gets benefit of deducting depreciation from ordinary income, but only being taxed on gain from sale as capital gain C. Time Value: Borrower still gets time value of depreciation deductions now, income later D. Not Applicable: Bec of Estate of Franklin (see below), you dont even get to this bec assumes NRD is included in Basis even when NRD > FMV at time of purchase, which Franklin rules its not E. Recourse Debt: See above for diff treatment to avoid conversion benefit iii. Avoids tax shelter of using higher depreciation deductions by including debt in Basis iv. Avoids disparity bet tax and economic gain/loss on sale b. Basis includes NRD Depreciation Deductions (in calculating Basis to determine gain on sale of collateral) (Crane) i. Can only take depreciation deductions when you have equity in asset (i.e., when Basis includes debt) ii. Benefit of depreciation deductions w/out tax on gain until sold balances fact that Amt Realized includes assumed debt c. When NRD > FMV at time of purchase, NRD is not included in Basis (Estate of Franklin) i. Applicable to Seller Financing w/ Leaseback: When buyer buys building w/ NRD to seller, and then buyer leases it back to seller, w/ buyers option to buy it at end of lease for balloon payment of NRD. Buyer usually pays pre-paid interest due immediately.

i.

If interest and principal payments to seller mirror rent to buyer, and seller has incidents of ownership, ct may consider transaction to be an Option to buy at end of lease, and not sale A. This is more like Option bec buyer really has no debt obligation (i.e., no equity) since will only feel obligated to repay NRD in unlikely event that FMV to be > NRD B. Buyer will more likely have equity when NRD < FMV or when they are close in value C. Seller is basically selling rights to take depreciation and interest in exchange for pre-paid interest iii. If determined to be Option, buyer cant take depreciation or interest deductions since no equity in asset and NRD not included in Basis iv. Doesnt overrule Crane and Tufts since those only held that if NRD > FMV, NRD goes into Amt Realized if its also included in Basis A. Here, Franklin says that you dont even get to Crane or Tufts since when NRD > FMV, Basis doesnt include NRD B. Crane and Tufts could still apply when NRD is a little less than FMV (i.e. close in value) and good chance FMV to be > NRD 3. Legislative Responses to Tax Shelters a. 465: Limits amt of deductions in purchase money debt (i.e., seller financed NRD) to extent of income earned from property (i.e., equity in property) b. 469; Passive v. Active Activities: Passive losses only offsets passive income (i.e., doesnt meet Material Participation Standard) i. Broader than 465 c. 3 Effects of these laws: i. Stops abusive tax shelters and deters economically inefficient activity ii. Very broad scope, which may deter even economically efficient activities iii. Doctrinal complexity as to whats passive loss or material participation

ii.

M. Damages
1. General: $ from damages received for personal physical injuries or sicknesses is excluded from GI (104(a)(2)) 2. Applies to all 3 major types of compensatory damages a. Non-pecuniary Damages: Damages from loss (e.g., harm) meant to place you in position had injury not occurred (i.e., tort compensatory damages) i. No Haig-Simons income bec no better off than before injury

Intended for involuntary realized gains (i.e., wouldnt apply if you cut off your own arm) iii. If no damages received, no deduction for loss A. Valuation problems B. Ppl would claim deduction for all pain and suffering and income every time you feel better b. Damages for Medical Expenses: i. Similar to someone who deducts medical expenses under 213 (Itemized deduction) A. But not really bec thats itemized, so more limited than exclusion c. Lost Wages i. Prof: Doesnt makes sense that its not taxed since its replacing something which otherwise would be taxed, i.e., income ii. But jury could take income tax into account (although not part of jury instruction) iii. Takes into account litigation fees (i.e., substitute for tax) A. But this isnt used to exclude other damages $ (e.g., slander) 3. Physical Injury a. No definition; suggested that its something you can see b. Excludes emotional injuries (Flush paragraph after 104(a)) i. But medical expenses damages for emotional injury is excludable c. Physical symptoms resulting/arising out of emotional distress are not physical injury 4. Lump Sum v. Installments a. Interest gained from lump sum settlement or damages after paid is taxable b. But under 104(a)(2), $ from damages itself (i.e., paid from D) is excludable, whether in lump sum or installments

ii.

N. Tax-Exempt Interest
1. General: Interest from State and local bonds is excluded from GI a. Complex issue and regulations as to who can issue tax-exempt bonds b. No restrictions as to who can buy them c. Exemption due to Implicit Tax on holders, since rate of return will be lower than corp bonds due to fact that its not taxed 2. Abuses by State and Local Govt a. Anti-Arbitrage Laws: Prevents local govt from using $ from bonds to buy corp bonds at higher rate b. Reg: Limits activities that local govt can issue bonds for (e.g., cant issue for private activities, rather must be sufficient public interest) c. Issue now w/ funding sports stadiums w/ bonds

i. ii. iii.

Fed govt loses out on potential taxable interest from corp bonds and is subsidizing private activity and city is beneficiary Could argue that it generates jobs and revenue, which increases tax revenue Also, w/out funding from bonds, team may move and cause city lots of lost revenue

IV. Deductions & Credits

A. Business Expenses
1. General (162): Deduction from GI all ordinary and necessary expenses paid in carrying on operations of a business or trade 2. Ordinary & Necessary a. Very fact-specific and deference given to fact-finder and IRS i. Standard used is that which is common and frequent (Gilliam v. Comr) ii. Should be ok if not personal or capital expenditure b. Appropriate and helpful to business isnt enough c. Must distinguish between bus deduction and capital expenditure, such as Goodwill, which isnt deductible i. E.g., Paying off debt of ones bankrupt company in order to preserve reputation and clientele in new bus isnt ordinary and necessary expense, rather is more like capital expenditure (i.e., investment of Goodwill whose useful life > 1 yr) and is merely appropriate and helpful to bus (Welch v. Helvering) d. Rarity isnt dispositive e. Litigation Expenses whose origin of claim is bus related are deductible (212); Otherwise, its nondeductible personal exoense i. Criminal charges and subsequent litigation are not ordinary and necessary expenses for most businesses, rather are nondeductible personal expenses under 262 (e.g., art; Gilliam) ii. Consider whether expense is inseparable and foreseeable to business (e.g., Truck driver getting in car accident; Dancer) 3. Expenses Contrary to Public Policy & Other Exceptions (i.e., Disallowances): Unless exception is provided in 162, they are still deductible (if ordinary and necessary) a. No violation of public policy for litigating and defending yourself, and would be deductible (if claim arises out of bus) even if found guilty (Comr v. Tellier) b. 162 amended after Tellier to provide public policy disallowance only when deduction would frustrate sharply defined national or state policies proscribing particular forms of conduct i. No deduction for bribes and kickbacks (c) A. Includes disallowance for payments for which state law imposes criminal penalties ii. No deduction for fines and penalties (f)

No deduction for treble damage payments under Anti-Trust laws c. No deduction for lobbying expenses of state legislators (e) i. There is still deduction for lobbying local officials (e)(2) ii. DeMinimis exception (allowance) up to $2k for in-house expenditure (i.e., you send one of your employees) (e)(5)(B) iii. Disallowance for any ads intended to influence general public w/ respect to lobbying/legislature matters (e)(1) A. But can deduct ads for Institutional or Goodwill purposes intended to advertise product/bus d. Disallowance for any expense related to drug-trafficking, except for cost of goods sold (280E) 4. Salaries: deductible if reasonable (a) a. Must distinguish bet actual salary and dividend or gift (which isnt deductible) which is disguised as salary (Exacto Springs v. Comr) i. Especially prevalent when employee is also substantial SH b. Independent Investor Test (ITT): In determining reasonability, focus on whether SH are receiving Fair Market Return, which is determined based on getting sufficient dividends and profits (Exacto Springs) i. Compare expected rate of return to actual return c. Disallowance for salary > $1m for CEO and 4 highest paid employees of public corp (162(m)) i. Exception (allowance) for performance based compensation/bonus A. Performance Based must be determined by compensation committee of board of directors, comprised solely of 2 or more outside directors

iii.

B. Business v. Personal Expenses

1. Business Clothes: 3 requirements for cost of clothing to be bus expense (Pevsner v. Comr): a. Required as condition of employment b. Clothing not objectively adaptable to general usage as ordinary clothing c. Not worn outside work 2. Child Care: Generally not deductible since choice to have kids is personal (Smith v. Comr) a. Rationale: Imputed income of caring for your own children is excluded, so paying for it isnt deductible i. Horizontal inequity bet those who care for their own and those that pay for child care b. Statutory Relief (Smith is still good law): i. 21: $3k credit for one dependant ($6k for 2) x certain %, depending on AGI ii. 129: Exclude up to $5k of employer provided child care

A. Amt excluded reduces amt of credit under 21 3. Travel/Transportation Expense a. Generally: commuting expense to and from work isnt deductible bec personal choice to not live within walking distance of employment, UNLESS: (Flowers; Hantzis v. Comr; Reg. 1.1622(e)) i. Reasonable and necessary ii. Incurred while away from home A. Home refers to place of employment or where there is bus relationship (Hantzis; Where ct disallowed travel expense bet Boston, which was deemd to only have personal purpose bec it was where P lived, and NY, where P worked and temporarily lived) iii. Necessitated by business exigencies b. Applies to extra traveling expense that is result of job requirement (McCabe v. Comr; Where P, policeman, needed to take longer route to work bec job required him to carry gun at all times) c. May be exception (allowance) for extra traveling expense incurred for transporting work implements (Fausner)

C. Deductible Expenses v. Capital Expenditures

1. General; Capitalized Assets: Some bus expenses cannot be deducted immediately, rather must deduct cost of depreciable asset w/ useful life beyond current tax yr (> 1 yr) over its useful life a. Rationale: Purpose of allowing bus deductions is to match up cost with related income that was produced from that activity. But if cost of long-term asset is deducted immediately, income for this yr will be understated and later income will be overstated bec income in future will be earned from this cost b. Consumption v. Income Tax: Could argue that were actually moving towards consumption tax bec we allow deduction for some costs that have benefit beyond current yr, which disregards later income from that asset 2. Statutes; Whats Capitalized a. Indopco: All costs that create benefit beyond current yr are capitalized b. 263: Any amt paid for new building or permanent improvements or betterments made to increase value of any property or estate is capitalized c. Reg 1.263(a)-1(B): Amts paid/incurred to add value or substantially prolong useful life or adapt to new or diff use are capitalized d. Reg 1.263(a)-2(a): Cost of acquisition of asset w/ substantial useful life after current yr is capitalized i. Interpreted by cts to include all related costs to acquisition (e.g., legal, brokerage, accounting)

Litigation Fees: Consider Origin of Claim Doctrine in determining whether origin of claim giving rise to litigation fees are for investment activity (and deducted as investment activity under 212) OR related to acquisition of capital asset, which must be capitalized (Woodward v. Comr) A. Litigation fees incurred by majority SH for appraisal of minority shares is capitalized as related cost of acquisition of shares (asset that has life > 1 yr), since appraisal is substitute for price negotiation of acquisition of stock (Woodward) e. 212; Investment Activity: Allows deduction by individual (no need for bus purpose/relation) for ordinary and necessary expenses paid/incurred for i. Production/collection of income (i.e., investment);OR A. Applies to cost for benefit to be used within current yr OR indirect cost of capitalized asset (i.e., an investment, even if not related to bus) ii. Management, conservation, or maintenance of property held for production of income f. 263A: Must capitalize for direct and indirect costs of selfconstructed asset i. These costs are added to basis of asset (as opposed to creating new basis for these costs as new asset) ii. Intended to avoid inequality to those who buy it instead 3. Repair & Maintenance v. Improvement a. General: Can deduct repair, but capitalize improvement b. Reg 1.263(a)(1): Must capitalize amt that: i. Adds value or substantially prolongs useful life; OR ii. Adapts property to new/diff use c. Reg 1.62-4: Repairs that arrest deterioration and appreciably prolong life of property are capitalized i. But can deduct cost of incidental repairs which neither materially add to value of property nor appreciably prolong its life, but merely keep property in an ordinarily efficient operating condition d. 2 Approaches in calculating baseline value in determining whether cost is repair or improvement (i.e., adds value/life or merely maintains value/life): i. Plainview Union Water: Baseline value is value before repair was needed (i.e., before problem arose) A. Consider Planned Usage, i.e., whether you knew of issue when you bought property. If you didnt know of issue, then its likely repair since merely returning value to what you thought it was (visa versa if you knew). Very subjective. ii. United Dairy Farmers: Baseline is value at time of purchase

ii.

A. Knowledge of issue is irrelevant; Objective and easier administrability 4. Intangible Assets (263 and Regs) a. General: Capitalize cost of acquisition of intangibles w/ > 1 yr life i. Training expenses for asset are usually deductible (unless significantly unusual) ii. Advertising expenses are usually deductible iii. In-house expenses to buy/create intangible asset are always deductible iv. Out-house expenses to buy/create intangible will be capitalized if asset is capitalized b. Capitalize costs that facilitate acquisition, creation, or enhancement of intangible asset that must be capitalized i. Creating/enhancing separate asset is sufficient, but not necessary to require capitalization ii. Look to transaction to which fees relate, not original motive and consider existence of future benefit A. E.g., Taxpayer gives retainer to law firm to not represent hostile company in takeover, and then credits retainer for legal representation in takeover. Must capitalize it since fees relate to takeover, which has future benefit (Data Corp) B. E.g., Can deduct expenses of fighting unsuccessful hostile takeover bec no future benefit and only protecting existing structure (Stanley) C. Includes legal and banking fees incurred by target company (aquiree) in takeover, since although aquiree has little control, theres still future benefit (Indopco v. Comr) c. Created Intangible Asset: Only capitalize cost of created intangible asset if its a separate and distinct asset

D. Depreciation
1. Purpose and General: Intended as cost recovery a. Amt you can deduct is limited to Basis b. 1016: Decrease Basis by amt of depreciation deductions over certain # of yrs until Basis = 0 c. Code imposes depreciation schedule i. Sort of overrules realization requirement bec allows deduction before asset is disposed ii. Justified bec we want to match income with related expense (incurred depreciation) of earning that income d. Only allow depr when asset depreciates as a result of use i. Use is cost of producing bus or investment income, not personal purposes ii. So no depr for land, stocks, or diamonds (and some other assets that dont depreciate with use)

e. 2 methods by which depr captures value of decline of asset over time: i. Economic Depr: Depreciate using Mark to Market A. Determined by calculating PV of income to be earned B. Depr increases over time (bec PV of income over time, so basis and deductions ), so (economic) income decreases over time ii. Straight-Line Depr (what we use): Constant deductions over time A. Preferable bec higher deductions and lower income earlier (time value of $) B. Criticism: 1. Inefficiency: No need for incentive bec these ppl wouldve invested anyways. Also, only incentive to invest in capital, not labor, and tangible, but not intangible assets 2. Couldve better designed incentives for investment, which Congress has shown capability of (e.g., 179, accelerated depr, shorter recovery period, yr) 2. Statutes/Law a. In general, Code allows for Accelerated Depreciation b. 167(a) i. Depr allowed for exhaustion, wear, and tear of: A. Property used in trade/bus B. Property held for production of income ii. Asset only needs to be subject to wear and tear or obsolescence (Simon v. Comr) A. No specific requirement that asset is actually depreciating in value and producing income (Simon; Where P was allowed to depreciate antique violins, which were actually appreciating in value, but depreciating in use value) B. Also no need for ascertainable useful life (Simon) 1. In order to avpid valuation issues, Ct wont bifurcate/distinguish bet useful value and market/antique value c. 168: Deals w/ tangible property i. Determine applicable recovery period (how many yrs to depr) for diff assets (c) A. 1st determine classification of property (e) ii. Salvage value is always 0 (b)(4) iii. Determine applicable Part Yr Convention (d) A. E.g., Yr (if you owned for < 1 yr), Mid-Month, Mid Qtr iv. Determine Depr Method (e.g., 200%, 150%, Straight-line) (b) A. Default is Double-Declining, and switches to straight-line when the 2 give same amt

B. Under double-declining, depreciate twice as much as straight-line and apply it to balance of Basis each yr d. 179: Could deduct (expense) portion of cost of tangible property immediately i. Limited to $25k/yr (100k for 02-10) (b)(1) A. Increased to $250k for 08 (179(b)(7)(A) and 09 (Stimulus Plan) ii. Amt of immediate deduction under (b)(1) is reduced by amt that cost of asset exceeds $200k ($400k for 02-10) (b)(2) A. Increased to $800k for 08 (b)(7)(B) iii. Applies only to tangible property or computer software (d) e. 197: Deals w/ intangible property i. Must amortize intangible property (e.g. Goodwill) over 15 yrs ii. No amortization of self-created intangibles (c)(2) A. But can deduct (expense) some costs of (e.g., advertising) (263)

E. Interest
1. Business v. Investment v. Personal Interest (163) a. All interest accrued/paid on indebtedness is deductible (a) b. Interest on purchase of investment property is only deductible to investment income (d) i. Disallowed amt can be carried forward c. No deduction for interest on purchase of personal asset (h) i. Intended to avoid tax arbitrage of using $ for tax-exempt asset but claiming its for personal use ii. Look to timing and use of loan (not asset securing it) in determining whether interest is personal or bus (Regs) A. Presumption that 1st purchase w/ funds determines use of loan (personal v. bus) iii. Qualified Residence Interest: Deduction allowed for interest on loan secured by home (i.e., home mortgage interest) (h)(3) A. Encourages home owning over renting, which creates stable community and children and better care of home B. Creates horizontal inequity to those who rent 1. Haig-Simons would call for including imputed rental income and disallowing interest deduction 2. But including imputed rental income creates valuation issues C. Intended to benefit lower income ppl, but actually benefits higher income ppl 2. Tax Arbitrage: Refers to buying tax-exempt (e.g., municipal bond) or tax-preferred asset (e.g., capital gains asset) w/ borrowed funds, which allows deduction for interest paid on loan and offsets income earned from asset

a. E.g., Buy $10k municipal bond w/ loan that has $10k interest. Although economically and Pre-tax its a wash and balances to 0, its profitable After-tax since he deducts interest, so interest cost is less and gain is bigger (assuming 50% marginal rate, after-tax cost of loan is reduced to $5k, and gain is $5k [$10k of tax-exempt income $5k after-tax cost of loan]) b. Statutory Responses i. Deduction is disallowed for interest on loan used to buy taxexempt asset (265(a)(2)) or annuity (264(a)(2)) A. Creates disincentive to make otherwise inefficient transaction ii. When using loan to buy tax-preferred asset, must either forego preferred tax rate and deduct interest, OR take preferred rate and not deduct interest (163(d)(4)) c. Judicial Responses: Cts can use several doctrines (e.g., economic substance, sham transaction) to disallow deductions bec of Arbitrage (Knetsch v. US) i. Cts may apply this when it determines that transaction is sham bec wouldnt appreciably affect beneficial economic interest from a Pre-tax perspective ii. Could also be applied when theres no economic substance or real indebtedness

F. Losses
1. General: Loss sustained (in sale of bus/investment property or in bus/investment transaction) and not compensated by insurance is deductible in yr sustained (165(a)) a. Must be closed and completed transaction to constitute loss (Reg 1.165-1(b) 2. Hobby Losses a. Losses from non-profit seeking activity are disallowed, except against income earned from that same activity (183) b. 9 factor test for determining whether activity is hobby or profitseeking (Reg 1.183-2(b); Plunkett v. Comr); i. Manner in which activity is carried out ii. Expertise of taxpayer or advisors iii. Time and effort in carrying out activity iv. Expectation of assets used to appreciate in value v. Success in carrying on other similar or dissimilar activities vi. Taxpayers history of income/loss w/ respect to the activity vii. Amount of profits earned viii. Financial statues of taxpayer ix. Whether elements of personal pleasure/recreation exist 3. Casualty Losses

a. In bus or income producing context, deduction allowed for amt of adjusted basis, even if > diff in FMV before and after loss (165(b); Reg 1.165-7(b)(2)) b. In Personal context i. Deduction limited to amt (165(h)): A. > $100; AND B. > 10% AGI ii. Limited to lesser of (Reg 1.165-7(b)(1)): A. Diff of FMV before and after loss; OR B. Adjusted Basis c. Must deduct loss by amt of insurance proceeds (Reg 1.184) i. Could result in gain if proceeds > loss, which is deemed as taxable sale to insurance co. d. No deduction when loss is intentional or from gross negligence on part of taxpayer (Blackman) 4. Investment Losses: Refers to losses sustained in profit-seeking activity, but not in trade/bus (which would be deductible from GI) a. Must be itemized, so only used when > Standard Deduction i. Not subject to 2% of AGI floor (167) b. Not subject to limitations of theft and other personal casualty losses 5. Related Party & Wash Sale Losses (i.e., Tax Shelters/Arbitrage) a. No loss allowed from sale bet related parties (267(a); related parties defined under (b)) i. But gain is recognized only to extent that it exceeds disallowed loss under (a), i.e., relative to whom its sold can use seller relatives disallowed loss to offset gain from subsequent sale to 3rd party (but cant be used to create a loss for subsequent sale) (d) b. No loss for exchange of substantially similar stock w/in 30 days (e.g., when I buy back stock that I sold you) (1091) i. Adjusted basis is transferors original basis +/ gain/loss when sold back to him c. Loss must be bonified (Fender v. US) i. Cts will consider substance over form, motive for transaction, change of economic status of ownership, and risk of not being able to repurchase (Fender; Where P had bus relationship and control over buyer Bank and knew he would be able to repurchase and sole motive for transaction was for loss) ii. Sale bet parties who have prior relationship and where seller exerts control over buyer may be deemed to be related parties (Fender) d. Equity v. Debt Holder in Net Lease: Refers to transaction similar to sale leaseback where A sells building to B, and then B leases building back to A while A pays maintenance and operating

expenses. A has option to buy/extend lease. Lease payments are close in value to principal + interest payments on mortgage. i. Lessor/buyer (B) will be considered owner of building for and be able to include rent as income and deduct depreciation and interest, while A deducts rent, based on several factors (Frank Lyon Co. v. US): A. Govt isnt losing any $ bec any deduction is matched by recognition of income 1. Prof: But doesnt consider diff brackets and income shifting B. Arms length transaction, evinced by independent 3rd party (e.g., A originally buys building from 3rd party subject to mortgage) 1. Prof: But 3rd party also has incentive to shift income C. Lessor/buyer bears risk of mortgage to 3rd party if lessee/seller defaults or doesnt exercise buy-back option 1. As risk increases, you become more of an equity holder (not debt holder) D. Existence of non-tax reasons for structuring transaction in such a manner, so less concern for income shifting/arbitrage (e.g., govt restrictions in Frank Lyon) ii. Otherwise, lessor/buyer (B) is merely making a loan to the lessee (A) w/ interest (which is disguised as purchase price and which is paid back by rent) and lessee is real owner. Lessor (B) has no income/loss from building, rather only has interest income on loan to A and lessee (A) gets depreciation and interest deductions. No rental income/deductions for anyone. e. Statutory Responses to Arbitrage: Consider At Risk Rules (465) and Passive Rules (469) discussed above in Effect of Debt on Basis & Amount Realized (III. L. 3.)

G. Personal Deductions & Credits

1. Standard Deduction (SD) a. Flat amt of deduction for differently situated ppl, depending on marital and familial status (63(c)) i. Partially phased out as income b. Rationale: Effectively sets min income subject to income tax for poor ppl who dont have itemized deductions i. But still subject to FICA Tax (SS and medicare) 2. Personal Exemptions a. Get personal exemption/deduction for being alive (151(d)(1)) b. Also get exemption for dependants (152) c. Phased out as income 3. Earned Income Tax Credit (EITC) (32) a. Eligible taxpayers get tax credit on portion of earned income

Earned Income refers to amt before above the line deductions (GI) and only includes income for compensation of services (e.g., wages, salary, tips) b. Refundable (could get $ from govt if no tax liability) c. Amt varies greatly whether youre married or have kids d. Inflation adjusted e. Phase-in & Phase-out %: Take credit % and deduct phase-out % (32(b)(1)(A) f. Tax Expenditure v. Direct Payment i. EITC is expenditure since giving $ by giving credit ii. Better than giving $ directly bec encourages working (but doesnt account for those who cant work) iii. Less stigma of being needy iv. Lowers welfare budget bec no need to actually distribute $ v. Less administrative cost bec no need for separate agency A. But IRS and Treasury may not be as well equipped as Welfare dept to determine who is needy vi. Also gives $, which is more valuable and flexible A. But maybe we want to incentivize certain activities (e.g., food stamps) 4. Itemized Deductions a. Must select it if > SD b. Deducted from AGI (below the line) c. Refers to all expenses not included in above the line deductions d. Subject to 2% floor of AGI (i.e., only deductible for amt > 2% AGI) (67) i. Some deductions arent (e.g., charitable deductions) e. Subject to 3% (now its 1%) haircut for excess amt of AGI > $100k (i.e., reduce itemized deductions by 3% of amt of AGI over $100k) (68) f. Administratively burdensome for taxpayers (disincentive) 5. Charitable Deductions (170) a. General i. Itemized deduction thats limited to 50% of AGI (b), not subject to 2% floor, but subject to 3% haircut ii. Personal Benefit: Must reduce deduction by FMV amt of personal benefit you receive in return, i.e., quid pro quo (Case Law) A. If no FMV amt for personal benefit (i.e., service/benefit isnt available on market), all of it is disallowed (Hernandez v. Comr) B. Donation to Scientology Church is deductible (Revenue Ruling overruling Hernandez) iii. Must to be qualified donee under 501(c) b. Services: Cant deduct value of contribution of services (bec we dont tax imputed income)

i.

c. Amount: Deduct full FMV of donation, even if it appreciated in value from when you bought it (e) i. 3 requirements to be able to deduct full FMV (and not just basis): A. Must be otherwise taxable at capital gains rate B. Given to charitable organization C. Must be real property, personal property, or intangible thats related to charitys tax-exempt function ii. Cant deduct full FMV of self-created works iii. If charity sells donation w/in 3 yrs, donor can only deduct it for amt that charity sold it for iv. Not taxed on appreciation as gain v. But cant recognize loss if it depreciated A. Could sell it 1st, recognize loss, and then donate $ d. Tax Expenditure/Consumption v. Income Measurement i. Could be income measurement since seems to be indirect consumption by taxpayer since someone else is benefiting from $ and may even be direct consumption bec of benefit of giving (so since theres consumption and not taxed, must be income measurement) ii. But Code treats it as below the line deduction (and limited to 50% AGI and 3% haircut), so not really income measurement e. Incentives/Rationale: to distribute funds from more wealthy poor and to good causes for public f. Problems i. Really only benefits wealthy since its itemized deduction, which only wealthy ppl use and more benefit to higher bracket ii. Some charitable organizations are for-profit, so no benefiting public 6. Medical Expenses a. Whats Deductible & Excludable i. Deduct medical expenses paid during the yr (213) A. (d) defines medical care B. Regs allow capital expenses for some expenses (e.g., glasses) 1. Could include piano lessons prescribed by orthodontist C. Excludes purely cosmetic surgery and expenses ii. Health Insurance premiums are deductible and Insurance receipts/proceeds (including premiums paid by employer) are excludable b. Itemized Deduction i. Not subject to 2% floor or 3% haircut ii. Only deductible to extent that it exceeds 7.5% AGI c. Classification i. Prof: Seems to be tax expenditure for consumption

May be diff than other consumptions since healthcare intended to return you to status quo A. But deduction is limited to > 7.5% AGI and inequitable in favor of those whose employers pay premiums (excludable) B. Could argue that IRS thinks you may overpay when paying out of pocket 7. State & Local Taxes a. Deduction for certain state and local taxes (164) b. Itemized deduction i. Not subject to 2% floor ii. Subject to 3% haircut c. Politically charged issue bec more valuable in states w/ high state and local taxes 8. Education Credits a. Hope Credit: Allows credit up to 100% of 1st $1k and 50% of next $1k (= max of $1.5k) for 1st 2 yrs of college for you, spouse, or dependant (25A(b)) b. Lifetime Learning Credit: Credit for 20% of $10k of education expenses that can be used anytime during life (25A(c)) c. Both are phased out

ii.

V. Whose Income Is It?

A. Taxation of the Family
1. Kiddie Tax: Kids < 18 pay tax on unearned income at parents tax rate a. Meant to avoid income shifting and treats family as economic unit 2. Marriage/Couples v. Individuals a. Joint-Filing: Married ppl have option to file jointly and be treated as economic unit i. Leads to marriage bonuses and penalties, depending on how much each spouse earns A. Bonus: When one spouse earns all the income and the other earns 0, theres bonus since income earner is taxed at lower bracket than if he were single B. Penalty: When each earns similar amt, theres penalty since taxed at higher rate than if they were single (bec income is combined) 1. Held to be constitutional (Druker v. Comr) 2. Arise bec cant simultaneously have progressive tax system, system that taxes equally all married couples w/ same total income, and system that is marriage neutral ii. Horizontal Inequity: Married ppl share consumption, so less expenses and joint savings iii. Alternative: Tax everyone equally and be marriage-neutral

A. Problem: This would lead to income shifting to lower bracket spouse iv. Compromise: To reduce marriage penalties, Code doubles standard deduction for joint filing couples, but doesnt double size (amt of income) of all brackets (only lower ones) b. Definition of Marriage: Federal Defense of Marriage Act prohibits same sex couples from filing joint returns, even if marriage is recognized by state i. Could be detrimental or beneficial (also depending on how much income each partner earns) A. Detrimental 1. Portion of health benefits provided by employer to employees partner isnt excludable to employee 2. Compliance costs of doing more tax returns and not being able to transfer same info from state to federal B. Beneficial 1. Requirement that couple filing separately both use standard deduction if one spouse elects it (63) doesnt apply to same sex couples 2. Prohibition of claiming loss on transfer of property to spouse doesnt apply to same sex couples

B. Divorce
1. Tax-Motivated Divorce: 2 taxpayers cant take advantage of filing 2 separate returns by divorcing solely for purpose of avoiding marriage penalty (e.g., divorcing last day of yr and remarrying next day) (Rev Ruling) a. Fed govt usually defers to state govt to determine validity of divorce b. Sham Transaction Doctrine: But fed govt will still look to substance over form, even if state validates divorce (Borax) 2. Alimony: Alimony payments are deductible to payor from GI (215(a)) and included in GI for payee (b) under 71 (which defines alimony) a. Limitations and Restrictions: i. Must be in cash ii. Must be result of separation/divorce agreement iii. Parties didnt earmark payments as nondeductible to payor and nontaxable to payee (which they could do) iv. X-spouses cant live together v. Payments must cease when payee dies vi. Cant be child support 3. Child Support: Payments related to contingencies in childs life arent deductible to payor and not included in GI of payee 4. Property Settlements a. Non-Recognition Provision: Transfer of property that is incident of divorce in divorce settlement is not a realization event and thus no gain/loss recognized (1041, overruling US v. Davis)

b. Transferee gets carryover basis from transferor (i.e., transferors adjusted basis) i. So although transferor doesnt recognize gain/loss, transferee eventually will when he/she sells it

C. Assignments of Income/Income Shifting

1. General: Income is taxed to person who earns it, and property is taxed to owner a. K w/ spouse to give of your salary to her will still result in all of it being taxed to you since K doesnt prevent you from receiving income (i.e., K gives more rights than under law) (Lucas v. Earl) 2. Shifting Bet Entities: Corp may shift income to foreign subsidiary in non-arms length transaction in order to avoid higher domestic tax a. E.g., If US tax is 35% and foreign tax is 5%, CGS is $100 b. US corp will sell to subsidiary for low price ($101) in order to show less profit in US ($1), and then subsidiary will sell for higher price ($200) and bigger profit in foreign country (200-101 = $199) and be taxed at much lower rate

VI. Capital Gains & Losses

A. Introduction to Capital Gains
1. Preferential Treatment: Lower tax rate on capital gains a. Arises when theres sale/exchange of capital asset i. Realization requirement allows for cherrypicking by selling losers and holding winners b. Interest income is not capital gain bec not from sale/exchange c. Gains derived from capitalized asset isnt necessarily capital gain d. Does not apply to corporations 2. Short/Long Term Capital Gains/Losses (1222) a. Amt Realized Basis = Gain (1001(a)) (i.e., basic rules of gains) b. Long Term: Asset held > 1 yr (3) i. Taxed at preferential rate (5/15%) A. If in 0 bracket, capital gains rate is 0 B. If Marginal Rate is 10 or 15%, capital gains rate is 5% C. If Marginal rate > 15%, capital gains rate is 15% c. Short Term: Held < 1 yr i. Taxed at regular rates 3. Netting/Basketing Rules (1222) (p. 541-42) a. Separate gains/losses between short and long term categories and net them in each category separately b. If total net is short term capital gain, its taxed as ordinary income c. If net is long term gain, taxed at capital gains rate d. If theres long and short term gain, both taxed at their own rates (i.e., long term gain @ capital gains rate, and short term gain @ ordinary income rate) e. If theres net loss, can offset up to $3k of ordinary income/yr

Applies even if loss is only short-term Loss in excess of $3k can be carried forward Corporations can only carry forward for 5 yrs A. But can carry back losses for 3 yrs 4. Rationale for Preferential Treatment a. Bunching: Bec gains arent taxed until realized, youre eventually being taxed on cumulative gains of holding period and will be taxed at higher Marginal Tax Rate (MTR) i. This is result of several Features of Tax System A. Realization requirement B. Progressive rates C. Annual income measurement ii. Alternatives to Preferential Treatment A. Mark to Market system B. Income averaging (i.e., apply rate that wouldve applied evenly over holding period) iii. Counter: You already get benefit of tax deferral till sale b. Inflation: Economic gain may be less than stated gain bec of inflation i. Features of Tax System: Partial inflation adjustment ii. Alternatives: Full inflation adjustment (but very hard to precalculate since usually done in hindsight) c. Lock-in: W/out preference, ppl wont sell, which discourages liquidity and causes inefficiency (ppl wont exchange assets that are more profitable on pre-tax basis) i. Features of Tax System A. Stepped-Up Basis under 1014 for bequeathed assets B. Realization requirement ii. Alternatives A. Repeal 1014 B. Mark to market C. Consumption tax (i.e., dont tax earnings if not consumed) D. Non-recognition rules (i.e., dont recognize gain on transfer and allow carryover basis for transferred assets) iii. Counter: Still incentive to hold till death (or at least 1 yr to get preferential treatment) d. Encourage Savings & Economic Growth i. Justifications A. Savings shouldnt be taxed like wages B. Dont want to discourage risky investment behavior (bec gains would be taxed as ordinary income but losses limited to capital gains) C. Encourage investment ii. Features of Tax System A. Income, not consumption tax (so no diff bet savings and wages)

i. ii. iii.

iii.

B. Loss limitations Alternatives A. Consumption tax B. Immediate deduction for savings C. Repeal preference and cut rates across the board

B. What is a Capital Asset

1. General: Capital asset is property held by the taxpayer (whether or not connected w/ his trade/bus) (1221(a)) a. Exceptions: i. Stock in trade or inventory of bus, or property thats held primarily for sale to customers in the ordinary course of trade/bus (a)(1) ii. Depreciable or real property used in trade/bus (a)(2) A. BUT if property falls solely in this category, take ordinary loss and capital gain (1231; basically overrides (a)(2)) iii. Literary/artistic property held by its creator, unless the creator of a musical composition or a copyright in musical works elects to treat it as a capital asset (a)(3) iv. Accounts or notes receivable acquired in ordinary course of taxpayers trade/bus (a)(4) v. US govt publications received from the govt at a price less than that which the general public is charged (a)(5) vi. Commodities derivative financial instruments held by commodities derivative dealers (a)(6) vii. Identified hedging transactions under rules provided in regulations (a)(7) viii. Supplies regularly consumed by taxpayer in ordinary course of trade/bus (a)(8) b. Still consider 165(c) (cant deduct personal expenses) 2. Depreciation Recapture (1245): For tangible personal property, treat gain as ordinary income to extent of depreciation taken on asset 3. Property Held Primarily for Sale to Customers (a)(1) a. Even if theres dual purpose for holding property, IRS must show that sale to customers is taxpayers primary motivation by showing that this is the most important reason for entering transaction (Malat v. Riddel; Where P bought land for dual purpose of either selling or renting to customers) b. Not enough if sale to customers is substantial reason c. Bifurcation: Taxpayer can bifurcate bus and investment aspects of trade/bus in order to label part of income as capital (Bramblett v. Comr) i. E.g., P owns partnership and corp. Partnership buys land for investment purposes, and then sells land to corp, which

develops and sells land to 3rd party. Partnerships gain is capital, while corps gain is ordinary under (a)(1) (Bramblett) ii. Ct will not assume that corp is agent of partnership (which would require partnerships gain to be ordinary since really primarily held for sale to customers) and treat them as separate entities, even in the face of substance over form (Bramblett) d. Rejection of Bus Motive Test: Bus motive is irrelevant in classifying asset as capital asset, rather its capital asset unless it fits squarely in one of exhaustive statutory exceptions (Arkansas Best v. Comr, qualifying Corn Products Refining v. Comr) i. Corn Products merely dealt w/ (a)(1) and interpreted it broadly to include future commodities (corn features) and consider it inventory (Arkansas Best) A. But cant say that we must look to Congressional intent to determine that 1221(a) wasnt meant to give capital preference to bus earnings, since statute is clear on its face 1. Parenthetical states that bus/trade is irrelevant 2. Exception list is exhaustive ii. This avoids ability to convert ordinary gains into capital gains by merely claiming that asset is sometimes capital (when theres gain) and sometimes not (when theres loss)

C. Non-Recognition (of Like-Kind Exchange)

1. Realization v. Recognition a. Could have realization, but not recognition b. Non-recognition essentially defers gain/loss, but does not obliterate it (not lost) 2. Rationale a. Avoids lock-in and encourages disposition of property to engage in more profitable investment b. Mere change in form c. Liquidity; no $ to pay taxes i. Prof: But still required to pay taxes on dissimilar exchanges 3. Applicable Transactions a. Non-recognition only applies to like-kind exchange of property used in trade/bus or investment, but not personal property (1031(a)) i. Some exceptions to bus/investment property that is recognized b. Like-Kind Exchange: Arbitrary definition i. FOR TEST: All real-estate is like-kind c. If one party doesnt have property yet, he has 45 days from date of transfer to find property, and 180 days from date of transfer to actually transfer it (a)(3) d. Boot: $ and non-like-kind property (FMV) received is included in recognized gain (b) 4. Basis & Amount Realized

a. Basis in new/received property is: i. Old Basis ii. +/ $ given/received iii. +/ Gain/Loss Recognized (from Boot)(d) A. Check answer by knowing that Basis always preserves unrecognized gain (i.e., = FMV of property received Unrecognized/Realized gain) b. Amount Realized = FMV of property received +/ $ received/given c. Realized Gain = Amt realized (old) Basis

VII. Timing; When is it Income

A. Taxable Year
1. 2 Basic Options: a. Periodic: Periodically require taxpayers to account for income i. This is what we do; Taxable Year A. E.g., Even if $ received is reimbursement for loss in previous taxable yr, its still income for this yr (Burnet v. Sanford & Brooks) ii. Could use Calendar or Fiscal Year (441) A. Calendar Yr: 1/112/31 B. Fiscal Yr: Any 12 month period that accurately measures income must be used (c) C. Must use taxable yr that clearly reflects income (446) D. Must get IRS approval to switch E. Individual who doesnt keep books must use calendar yr since assumed that otherwise wouldnt accurately measure income (g) iii. Inequitable treatment to those who earn same amt over few yrs, but either fluctuate or have same amt over those yrs (results in diff brackets for these 2 ppl) A. Some call for income averaging b. Transactional: Require taxpayer to account for certain transactions when they are complete i. Allows you to always offset income w/ related expenses, which is more accurate measurement of income ii. Problem: Difficult administrability as to when transaction is complete 2. Claim of Right Doctrine: Refers to situation where income reported in yr 1 must be returned in later yr (claim of right to income in yr 1) a. Law: Must include income when received and then get deduction for any amt included when its returned (US v. Lewis) b. Deduction i. When taking deduction in yr of return, you could deduct larger of (1341(a)): A. Amt you would save if you take deduction in yr of repayment (now); OR

ii. iii.

B. Amt you wouldve saved if you never included income in yr 1 I.e., Use larger tax rate of yr of inclusion or yr of repayment This avoids unequal value of deduction and inclusion due to diff tax rates in diff yrs

QUESTIONS 1) Is there any statutory authority for excluding travel expenses (e.g., 132, Fringe Benefits)? Or is there just Gotcher? 2) For public policy exception to 162 (bus expenses) besides for (c), (f), and (g), is there general exception for deduction that would frustrate sharply defined national or state policies proscribing particular forms of conduct? 3) How does Hantzis line up with Flowers? If theres disallowance for travel expenses to and from work, how can there be an exception for expenses incurred away from home (which is defined as a place having bus relationship), which essentially allows for an expense to and from work (i.e., Could P deduct travel expense bet work and home in NY?)? How does a residence ever have a bus purpose? Is it because, defined this way, theres really only an exception for travel bet 2 places that have bus relationship? 4) Is 212 essentially allowing individual to deduct any cost for investment? How does this work? Is this supplementary to regular bus expense? 5) Under 263, if in-house expenses to create/buy intangible asset are deductible, then whats capitalized? What expenses in particular is it referring to? 6) How can 263 require capitalization of a self-created intangible asset, but then not allow amortization under 197(c)(2)? Does that mean theres no cost recovery until sold? 7) Are dividends considered capital gain?