CHAPTER 1 – INTRODUCTIONCode - § 1(a)-(f), (i)A. Orientation; The Tax Practitioner’s Tools (p. 1-11, 24-30, 42-46)A. The Importance of Income Taxes

1. Some Data on Taxes and the Distribution of Income Nearly all individuals will at some time file a federal income tax return – the infamous

Form 1040 In 2005, approximately 134 million individual income tax returns were filed. Of these,

approximately 53 million returns were joint returns filed by married couples, while 59 million returns were filed by single individuals

2. Impact on the Practice of Law Income tax affects a lot of branches of law and presents many opportunities for

adjustment of conduct to get desirable tax results3. Economic Consequences

Income tax has a substantial effect on allocation of resources in our country. The tax system is used to deliver an enormous range of incentive provisions for different kinds of business investment.

Income effects are changes in behavior induced by the fact that the tax reduces money available to the taxpayer. Substitution effects are changes in behavior that arise from a change in the relative attractiveness of different commodities or activities.

B. History The current federal income tax is a creature of the 20th century. Pollock v. Farmers’ Loan and Trust Co. – the income tax became a law in 1894; this case

declared the entire law invalid as unconstitutional Sixteenth Amendment – Congress shall have the power to lay and collect taxes on incomes,

from whatever source derived, w/out apportionment among the several states, and without regard to any census or enumeration

Our tax is a “mass tax” imposed on people across broad range of income spectrum. Alternative minimum tax – imposes tax at a rate of 26% or 28% on income more broadly calculated than under the regular tax, subject to an exemption amount, if alternative tax is greater than regular tax.

Tax Reform Act of 1986 – reduced the minimum marginal rate to 28% Flat tax plans – would eliminate many deductions/other provisions designed to affect

behavior; would turn income tax into consumption tax.F. Compliance and Administration

1. Self-Assessment, Audits, and Tax Litigation Our income tax relies on initial self-assessment, which means that one year each

individual or entity subject to the tax makes a calculation of the amount of tax owned. IRS – branch of Treasury Dep’t responsible for the administration of tax laws (headed

by Commissioner of Internal Revenue) Internal Revenue Code – federal statutes written by Congress (not the IRS). IRS is

charged with enforcing what is written. Person who fails to file an income tax return may be subject to both civil and criminal

penalties. There is no SOL on civil penalties. There is a 6 yr SOL for criminal. IRS ordinarily has only 3 years to assert a deficiency. Audit – more complete review of

a return. Chances of an audit are small.2. Penalties for Noncompliance

A substantial understatement is one that exceeds the greater of 10% of the proper tax or $5000 ($10,000 for corporations), but the amount of the understatement is reduced by amounts attributable to treatment for which there was “substantial authority” or

amounts “with respect to which the relevant facts affecting the item’s tax treatment are adequately disclosed… and for which there is a reasonable basis.”

Penalties may be waived by IRS if taxpayer demonstrates “reasonable cause” and “good faith.” Taxpayer may alert IRS to “red flags” on return.

Adjustment – correct the problem in the net year. Amended return – correct the problem by filing a supplement to the return.

J. Sources of Federal Tax Law in a Nutshell Taxes are imposed only by statute IRS

o Rev Rulings – opinions on matters of law arising in particular fact settingso Revenue Procedures – statements describing procedures affecting the rights or duties

of taxpayers or other informationo Private Letter Rulings – issued to taxpayers in response to requests for advice about

their own specific fact situations The opinions of the Tax Court fall into two categories:

o Regular decisions which are published by the court itselfo Memorandum decisions which are not officially reported but are published

commercially by Research Institute of America and by Commerce Clearing HouseThree Options Available for Judicial Review:1. Tax Court (don’t pay first)

Originally an arm of the Dep’t of Treas – admin/Article I court Limited jurisdiction – only hears tax controversies Judges tend to be lawyers who have a strong background in private practice of tax; expert

judges, no jury in tax court Has its own body of persuasive precedent; federal district court ruling may be persuasive but

not binding Where you want to go next (ct of appeals for taxpayer’s circuit) Only court where you don’t have to pay tax first and then sue for refund; can bring suit in tax

court based on protest letter2. Sue for a refund in the federal district court where the taxpayer resides

Taxpayer v. United States Court of general jurisdiction so judge may not be a tax expert Taxpayer can have a jury if they want one System of binding authority; other district courts are persuasive, ct of appeals is binding (as is

supreme ct) Appeal to court of appeals for the district where taxpayer lives You do have to pay the tax to have standing to bring suit

3. Sue for a refund in the United States Court of Federal Claims Also an Article III court Limited Jurisdiction – hears only claims of money against the United States – you have to pay

the tax first in order to have a claim Judges are experts in money but not necessarily experts in tax Taxpayer does not get a jury in this court Court has own precedents; not bound by tax or federal court Has their own court of appeals – federal circuit court of appeals for the federal circuit – hears

mostly tax cases and cases from the patent and trademark courtHow do we get into court?

The IRS never has to start litigation; in all three of these courts, it is the taxpayer who starts the litigation

If the taxpayer does not pay, the Commissioner puts a tax lien on the property. The Commissioner does not have to sue and prove he is right; you have to sue and prove he is wrong.

Where to look? Code (Example §212) Regulations under the Code (Example §1.212)

o Entitled to most deference of all things the IRS issues Legislative History – Committee Reports (but people usually go to the Regs. First)

§ 7805 – designates Sec. of Treasury to write “all needful rules for the enforcement of the Code” Cannot write a new law The regulation is invalid if it exceeds the statute that it is written under Revenue rulings – answers to particular taxpayer questions about what the IRC means. Less authority than a

regulation, but still good authority. (Rev. Rul. 75-423 (423rd ruling issued in 1975); 2002-186 (186th ruling issued in 2002)

Revenue Procedures (equal authority as revenue rulings) – rulings dealing with interpretation of substantive law, procedures deal with procedural/administrative questions. Rev. Proc.

All revenue rulings begin with “advice has been requested…” A revenue Ruling is binding on the taxpayer that requested the advice; persuasive authority to other taxpayers in

same situation Rulings cannot conflict with statute or Regulations. Regulation controls if ruling conflicts; code controls if

regulation conflicts Private Letter Ruling (pvt. Ltr. Rul. Or P.L.R. 2004-21-389; year-week-number of ruling in which it was issued) –

answer to taxpayer’s question. Private letter ruling is binding on taxpayer who answered it; it’s authority but not persuasive authority for another taxpayer.

B. Cesarini v. United States (handout, p. 42-46, 84-88)Cesarini’s found old currency in a piano they bought at an auction for about $15 (currency worth over $4k). They had a “tax event” (realization – occurrence that requires a payment of tax.) §61(a) – definition of general income. Regs 1.61-14 – treasure trove is included in GI. The money is taxable income; it did not actually belong to the Ps until they found it (according to OH law). What if they found out the piano was worth more than $15 rather than finding the currency? Finding out the quality of an item you already own isn’t realization for tax purposes. Finding out you have an additional asset you didn’t have before is realization. Must be the ability to separate a new asset from the old one).C. Windfalls and Gifts

1. Punitive Damages Earlier Supreme Court opinion, Eisner v. Macomber (192), which narrowly defined the

term “income’ as “the gain derived from capital, from labor, or from both combined. In many ways, Glenshaw Glass is less about punitive damages than about the

continuing vitality of Eisner v. Macomber, as well as the Supreme Court’s rule in policing the contours of the term “income.”Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)

“Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”

C. Introduction to Tax Policy and Rate Structure (p. 11-24) (Code §1(a)-(f), (i)C. Theory and Policy

1.Taxation and “Ability to Pay” “Head tax” – a tax of equal dollar amount on everyone Our income tax is based on an “ability to pay;” a phrase of which the meaning is

disputed. Consumption tax has been seriously considered “Imputed income” – value of goods and services one provides to oneself

6 aspects of a good tax1. Uniformity – geographical uniformity

2. Equity – horizontal (people with same accessions to wealth pay same tax amount – same income, same tax liability. People making the same amount of income should pay the same amount of tax. If I make $50,000 and my neighbor makes $50,000, we should both pay the same tax); vertical (different accessions to wealth have different tax liability. Different income, different tax liability. Up and down the economic scale. )

3. Predictability – a good tax should have the same effect from year to year4. Simplicity – good tax law should be easy enough for average taxpayer to fill out their

own tax return. Our current tax law is not very simple5. Administrability – related to simplicity; what does government have to do in order to

enforce tax laws? Do they spend more than they collect?6. Neutrality – a good tax shouldn’t effect non-tax business decisions

2. What Should We Tax? Once one accepts that some variant of ability to pay ought to serve as the touchstone

for allocating tax burdens, the question becomes how to implement it. Since the thing we really want to tax may not be directly observable, we must rely on some proxy measure. There are numerous possibilities (income, consumption, and wealth being some).

A consumption tax is simply an income tax with a deduction for savings in any form and with the inclusion in the tax base of amounts drawn down from savings and used for consumption. IRA

3. What Do We Tax? Income Haig-Simons definition of income calls it the sum of the taxpayer’s consumption plus

the change in net worth, each defined in terms of market value, during some specified accounting period

In practice, the US federal income tax liability depends on the statutory concept of “taxable income,” rather than on any abstract definition

4. The Tax Expenditure Budget Tax scholars often refer to a concept called the “tax expenditure budget,” under which

certain tax benefits are equated with direct subsidies. The general approach is to identify various exclusions (such as interest on state and local bonds), deductions (such as deduction for charitable contributions), deferrals (such as for employer payments to pension plans), and credits (such as the child-care credit or the credit for investment in new equipment) that are seen as departures from a neutral concept of income taxation; then to figure out the cost of these special provisions; and then attribute these costs to various budget functions.

Depends on the notion that there is a natural, neutral, or normal income tax and that it is possible to identify departures without great difficulty or dissent.

5. Tax Incidence The incidence of a tax is its ultimate burden To determine incidence of a tax (burden/effect of particular provision of a tax system),

compare the world with the tax provision to the worth without it. It’s generally assumed that the burden of the income tax, so far as it falls on income from wages, salaries, and other earnings from services, is, for the most part, not shifted from the individuals to whom it is imposed.

6. Inflation Section 1(f) and 151(f) Income makes it difficult to levy the right amount of tax on investment income.

D. Average Versus Marginal Tax Rates One of the most controversial features of any tax system is the extent to which it redistributes

income or otherwise requires some people to pay more than others.

A progressive income tax is one with average rates that rise as income rises. Under a progressive rate structure the tax on a person with a high income is not just a greater amount than the tax on a person with a lower income; it is a greater proportion of income.

A regressive income tax is one where average tax rates decline with income. Overall, the U.S. federal tax system (including all taxes, not just income taxes) generally

features progressive tax rates, though the degree of progression varies depending on the tax. WE have graduated rate structures (Hess thinks the consensus is shifting from graduated rate structures to proportional).

Within the individual income tax, progression is accomplished primarily by a schedule of rates with increasing marginal tax rates – that is with increases in rates that apply only to increments in income.

E. The Taxable Unit and the Marriage Penalty A “taxable unit” means that individual, or group of individuals, who is, or are, treated as a tax

paying unit in the same sense that they must aggregate their income for purposes of calculating the tax payable. Married people permitted to file joint return – most favorable; heads of household, unmarried individuals, married people filing separate returns – least favorable

“Marriage penalty” – added tax paid by two people who have roughly the same earnings and who marry one another. “Secondary worker” person whose income is lower and whose commitment to working is less than the primary worker

Married single-earner couples are better off than they would be under a system with one schedule for all, since they have the advantage of the most favorable rate.

CHAPTER 2 – SOME CHARACTERISTICS OF INCOMECode - § 61, 102, 1001(a), 1011, 1012, 1014, 1015(a), 1016(a)Regs - §§ 1.61-1, -2, -14, 1.102(f)(2), 1.102-1, 1.1001-1(a), 1.1015(a), 1016(a)

A. Noncash Benefits (p. 47-49, 70-77) What is income? As a legal matter, the short answer is: whatever the IRC is authoritatively

(and constitutionally) interpreted to say that it is. The IRC defines “gross income” as “all income from whatever source derived” (§61(a)) Regs. 1.61(a); 1.61-2(d)(1); Noncash benefits can be included in income. Noncash benefits

may make enforcement difficult; cheating often hard to detect.4. Economic Effects: An Example Parking example. Receiving free parking from employer v. receiving in cash what the

parking would have cost each month ($50). Employer setting ahs mainly been characterized by an all-or-nothing approach to including in kind benefits (non-cash).

5. Another Approach to ValuationTurner v. Commissioner, 13 T.C.M. 462 (1954) – man won two first class tickets for a cruise

with value of $2,200. He traded to get four regular class tickets. H reported $520 on the joint income tax return. IRS said he didn’t report enough. He didn’t report the full value of the tickets because he didn’t realize full value (even if he had, tickets had decreased in value because they were nontransferable/nonrefundable). Court came up with $1400 for the value; some value had to be assigned). (halfway between what the Commission claims and what the taxpayer claims). Most think Turner is wrong.

Definition of fair market value – amount that a willing buyer would pay to a willing seller if both of them knew all relevant economic facts and neither was under any compulsion to buy or sell (all four factors must be present)

o Completely objective standard – usually comes out half way (so just compromise and save yourself a trip to court). Subjective tests in tax are difficult to enforce because subjective aspects are in the control of the taxpayer.

Kid Who Catches Homerun Ball What if ball is worth 1 million when he catches it and he sells it for 1.5 million a year later?

He has 1 million in gross income in the year he catches the ball. What he got (1.5) minus what he already paid tax on (1 million) is what he pays tax on in the year he sells = 500,000 in gross income. This is called gain from dealing in property – one example of income in Section 61.

Hypo: 3 taxpayers all live in the same city and work for different companies. Taxpayer A works for Company A; Company A notifies its employees that they will get

$20,000 in cash raises. Taxpayer B works for Company B; Company B wants to give all of its employees stock in

the company. B is going to receive stock that is worth $20,000 on the day it is distributed. Taxpayer C works for Company C. C receives a brand new car titled in his own name and

has a FMV of $20,000 on the day it is transferred from the Company to C.Glenshaw Glass says you have gross income any time you receive something that makes you richer; all accessions to wealth clearly realized are income. Section 61(a)(1) says compensation for services is gross income. Salaries of the three taxpayers are clearly gross income. What about the raises?

A has gross income if his salary is $20,000 higher this year than last. B – is the receipt of stock gross income? Gross income doesn’t have to be cash so we don’t

have to sell the stock in order to realize gross income. B is richer because he has control of the stock and could sell it for cash at any time.

C has gross income for the same reason as B. C has gotten something of value. A-C have gross income, have it this year (the day they receive the item), and it is worth

$20,000. 61(a)(1). BASICALLY, YOU HAVE TO ASK THREE QUESTIONS (WHETHER IT IS INCOME? (you have to ask this first in order to answer the next two) WHEN IS IT INCOME? AND IF THAT HOW MUCH IS INCOME?).

B. Imputed Income (77-84) People may use their property or their own services to provide benefits directly to themselves

or to members of their households – for example, when they occupy houses that they own, when they care for their own children, or when they prepare their own tax returns. The benefits they derive are not part of any commercial transaction. Experts refer to these kinds of benefits as “imputed income.”

Imputed Income (II) is self performed services and use of one’s own property. Example – if Hess writes a will for herself, if her neighbor fixes outlets in his own home. Imputed income is NOT INCLUDED in Gross Income; Congress has never written an exclusion.1. Property Other Than Cash

a. The best and most significant example of imputed income from property is the owner-occupied home. The imputed income is simply the rental value of that home.

i. Imagine there are two taxpayers, A and B, each earning $50,000 per year. Each inherits $100K, which is tax-free.

1. A invests the $100K in U.S. bonds that pay her $8K each year. She continues to live in a house she rents. Her income will be $58,000; there is no deduction for rent, since it is a personal expense.

2. B uses his $100K to buy an identical house next door to A’s. He figures in the first year he will earn a return of $5000 in the form of the rent that he saves plus $3000 from the increase in value he expects. His return will be 8 percent. But his income of tax purposes will be only his $50,000 salary. The $8,000 return on investment in the house will escape

taxation. The $5,000 rental value is imputed income. It is never taxed. The $3,000 increase in value of the house is unrealized income and is taxed only on ultimate sale of the house, if at all.

b. The owner-occupied home; section 102(a), 262c. Borrowing money to buy a homed. Benefit derived from investments in residences will also be derived from investments

in vacation homes, yachts, consumer durables, etc.e. Time sharef. The person who borrows to invest in a personal residence relies on a combination of

two tax rules: 1) the non-taxation of imputed income, and 2) the deductibility of the interest payment

2. Services Working overtime to allow for extra money to pay for services versus not working

overtime and performing them yourself Services performed full time – homemaker Human capital – going to medical school, law school, etc Services for services and property exchanges are not II

3. Psychic Income and Leisure4. Drawing the Line

Distinction between imputed and non-cash benefits – Rev Rul 79-24. FMV of traded services includable in Gross Income. FMV of services for rent included in FMV.

Hypo: Hess did a will for her neighbor; her neighbor repairs outlets in exchange. Who has Gross Income? When? How much? Both have Gross Income. Amount of GI is FMV of what each received (FMV of five outlets, fmv of will). If either one of these were performed alone as a gift, it would not be gross income.

o This is a services for services transaction. It is NOT imputed income. There is no tax basis for an individuals labor. When it is converted into something you want (5 outlets), you are richer, the gross income is the five outlets.

o There is a serious administrability problem. Things like this happen all the time and aren’t reported. There isn’t enough tax liability involved for the Commissioner to pay someone to prove it.

A services for services swap (or goods for goods swap) is undeniable accession to wealth. Code 6045 requires information reporting by any “barter exchange.” Regs. 1.6405(a)(4) provides the term barter exchange does not include arrangements that provide solely for the informal exchange of similar services on a noncommercial basis.

Non-taxation of imputed income rests on no specific Code provision but simply results from a long standing administrative practice of the IRS.

C. Windfalls (reprise); Gifts (p. 32-35, 84-106)H. Some Tax Terminology and Concepts

1. The Tax Base and Calculation of the Tax Payable Tax base is not part of the specialized vocabulary of the IRC. It refers to a general

concept used by lawyers and economists to describe the amount that is to be taxed under whatever system of taxation one adopts – that is, the amount to which the appropriate tax rate is applied.

Taxable income is the bottom line. However, the term “taxable income” is itself defined by reference to certain other statutory terms of art. The starting point is the taxpayer’s gross income.

Gross income is defined by an elaborate set of rules found in the IRC, the case law, and other sources of tax law. The statutory centerpiece is §61.

Once a taxpayer’s gross income has been determined, the next step is to calculate adjusted gross income, or AGI, another statutorily defined term that is arrived at by deducting (subtracting) from gross income a set of items listed in §62.

The next step is to move from AGI to taxable income. This involves deducting a) the amount of the personal exemptions of the taxpayers and their dependents, if any, plus b) either i) the standard deduction or ii) “itemized” deductions.

The next figure arrived at by deducting from AGI the personal exemptions and either the standard deduction or the itemized deductions is, as previously stated, called taxable income.

G. Windfalls and Gifts If it is truly a gift, it will not be taxed. First question you need to ask is WHETHER it is income. Reasons why you don’t want to tax gifts (avoid double taxation, encourage wealth

transmission, administrability)1. Punitive DamagesCommissioner v. Glenshaw Class Co.

Whether money received as exemplary damages for fraud or as punitive two thirds portion of a treble damage antitrust recovery must be reported as GI under §22(a) (current §61). There is no constitutional barrier to imposition of a tax on punitive damages. 22(a) – GI includes “gains or profits and income derived from any source whatever.” It could not be justified in the absence of clear congressional intent to say that a recovery for actual damages is taxable but not the additional amount extracted as punitive for the same conduct which caused the injury.

What tax lawyers remember from this – “We have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”

Realization is ability to control, not physical control. o Anything that makes you richer is something that Congress can tax.o Section 61’s broad language says Congress will tax everything they cano If you want to argue something is exempted from taxes, you must find

something in the code that excludes it It would offend one’s sense of fairness to tax wages a person earns by hard work but

not money a person happens to find lying on the street. In a footnote, the Court attempts to reconcile its holding with the rule that damages for

personal injury had been excluded, for many years, by administrative rulings.2. Gift: The Basic Concept

Gifts have always been excluded from taxable income under what is presently Section 102. It applies to small and large gifts. What is a gift is question of fact.

Commissioner v. Duberstein Duberstein received a Cadillac from a business acquaintance. Staton received his gifts

as a sort of severance package from his employer. A voluntary transfer for no consideration is not necessarily a gift; most critical consideration is transferor’s intentions; must be an objectivity inquiry. Duberstein did not have a gift; he had gross income. Staton – no record of findings by district court so the case is remanded.

§102 is not a gift tax statute; it is an income tax statute. A gift is a transfer that results from detached and disinterested generosity; philanthropy like motives; benevolence; etc.

Gift – donor is alive; Bequest, devise, inheritance – donor is deado Bequest – traditionally a gift in a will or personal propertyo Devise – gift in a will of real estateo Inheritance – transfer by intestate succession

§102(c) was added after Duberstein. When an employer transfers something of value to an employee, it isn’t a gift; it is included in GI when (c) applies. According to (c),

Stanton has GI. According to (C), Duberstien isn’t an employee. 102(a) applies to Duberstein and we have to decide disinterested genorsity.

United States v. Harris Kritzik gave lots of money to twin sisters. They didn’t record it on income tax returns

because they considered it a gift. Critical consideration is intent of the transferor. Duberstein was a civil case; its approach was only for civil cases. The only time payment like this would not be a gift if it was specific sums for specific sexual acts – prostitution. A person is entitled to treat case and property received from a lover as gifts, as long as the relationship consists of something more than specific payment for specific sessions of sex.

D. Transfer of Unrealized Gain; Recovery of Capital (p. 37-38, 111-18, 119-22)4. Realization and Recognition

Realization and recognition are important terms of art in tax law. A gain or loss is said to be realized when there has been some change in circumstances such that the gain or loss might be taken into account for tax purposes. A gain/loss is said to be recognized when the change in circumstances is such that the gain/loss is taken into account. When there is a realization, there may or may not be a recognition. Where there is a recognition, there must have been a realization.

“what you got” “what you paid”§ 1001(a) – gain = amount realized – adjusted basis

§ 1000(b) §§ 1011, 1012 et seq.

Cash and property Cost (unless…)

Received

4. Transfer of Unrealized Gain by Gift While the Donor is Alive Surrogate taxpayer – person who is taxed on income of another person. Sec 61(a)(3)

includes in GI “gains from dealings in property.” §1001 provides that the Gain = AR – AB

Adjusted basis is defined in 1012 as cost (w/exceptions) adjusted as provided in 1016 (exception in 1015 for property acquired by gift).

If at the time of the gift the donor’s basis is greater than the fmv of the property (so the donor would have a loss if he or she sold the property), then for the purposes of computing the donee’s loss (but not gain) on any subsequent sale, the donee’s basis is the fmv at the time of the gift.

Adjusted basis - §1011 – unless there is a provision telling you to go elsewhere, basis is determined under §1012 (and then adjusted under §1016). Amount realized - §1001(b) – the sum of any money received plus the fmv of any property received (usually will be either/or but not both; either cash or property).

If you can’t determine the amount the gift was worth at the time it was given, the basis is zero. Your gain would be 100% of the amount realized.

Taft v. Bowers A purchased 100 shares of stock for $1000. He gave them to B when the fmv was

$2000; B sold them for $5000. Should b have to pay tax on $3000 or $4000? §1015 – applies for determining basis of property acquired by gift; basis is the cost of donor. Gain = AR – AB = $5000 - $1000 = $4000. Only taxable income on the increase that occurred while he owned the property…

5. Transfers at Death Inherited property – under 1014, basis of property acquired by reason of death is the

fmv on date of death or, at the election of the executor/administrator under 2032, on the optional valuation date (6 months after death). The full value of property may be subject to an estate tax. Failure of the income tax to reach the appreciation in value of assets transferred at death is most serious defect in our federal tax structure.

Examples: In the easiest situation, the person bought something in cash and sold it in cash.

o In yr 1 – taxpayer bought something for $10K (adjusted basis)o In yr 4 – taxpayer sold the same something for $16K (amount realized)o Gain = $6000

Another example… stock given in year one.o Yr 1 – stock give for $10K (FMV). You pay tax on $10K. As if taxpayer received

$10K from employer and bought the stock.o Yr 4 – Sold stock for $16Ko Gain = $6K

When you are buying and selling property, you only pay tax when you sell the property and excess of that.

Income in respect of a decedent – although 1014(a) relieves from taxation income or gain that had not been realized at the time of decedent’s death, under 691, income or

gain that had been earned before death is subject to a different set of rules. “Income in respect of a decedent” is a term used in section 691 but not defined anywhere. It is not

PROBLEMS – p. 1181. Suppose A purchases stock for $1000 and gives the stock to his son, B, at a time when the FMV

of the stock is $2,500. Under §102(a), B does not have any gross income when B gets the stock from A.

a. How much gain does B recognize if he sells the stock for $3,500? When you have income with a gift you have to pay tax on it. Under Section 1015, his basis is his father’s basis!

i. AR - $3500; AB - $1000; Gain $2500b. How much gain does B recognize if he sells the stock for $1,500?

i. AB - $1500; AB - $1000; Gain $5002. Suppose C purchases stock for $2000 and gives stock to daughter, D, at a time when the FMV of

the stock is $1000. What amount of gain or loss (if any) is recognized by D on a sale for the following amounts?

a. $2,500i. AR - $2500; AB $2000; Gain $500

b. $500i. If C sells, $500 = AB $2000 – AR ($500) = $1500 loss (deduction from gross

income)ii. If D sells, $1000 (AB) - $500 (AR) = $500 loss (deduction from gross income)

(Look at §1015(a) – FMV is less than basis when the gift was made and we are determining loss). Gets really odd when sale is between FMV and basis.

c. $1,500i. There is no tax consequence.

1. AR (1500) – AB (2000) – can’t do that (negative gain)2. AB (1000) – AR (1500) – you can’t have a negative loss

3. During the next four years, Ernesto’s daughter, Ana will require $80,000 for college tuition and expenses. In each of the following settings, advise him to the best means of transferring wealth to the daughter so that she may go to college. Ernesto is in the maximum marginal tax bracket and Ana has no income.

a. Ernesto has a single asset, stock with a basis of $20,000 and a FMV of $80,000i. Give it to Ana and let her sell it, put the money in the bank to pay the tuition each

year. ii. OR give her about $20K of stock each year to sell and pay for tuition – Yr 1: AR -

$20,000, AB - $5000 (1/4 of 20 bc 20 is ¼ of 80), Gain $15,000. Ana’s tax liability would be less than Ernestos’ because she is in a different tax bracket (less income is taxed because she has a lower total income).

b. Ernesto has a single asset, stock with a basis of $120K and a FMV of $80,000i. Don’t assume any gift at all. Let’s just say Ernesto sells the stock. Loss Equation.

AB ($120K) – AR ($80K) = loss ($40K)1. It reduces his gross income (Ernesto’s). §165(a) – I can take $40K off my

gross income this year. Let’s say he has GI of $150K. Take $40K away. He will only have taxable income of $110,000.

ii. If Ana had sold the stock, things would be very different. Computed under §1015(a). $80K (AB) - $80K (AR) = $0 (no loss here). If the family wants to use the investment loss, it has to be Ernesto’s, not Ana’s.

limited to items of income from the performance of services or to items of ordinary income. It does not include gain on assets owned by the decedent and not subject to any contract for sale at the date of death; if it did, there would be nothing left of the 1014 stepped-up basis at death.

Most common examples – flooding and extracted minerals.E. Transactions Involving Loans and Loan Discharge – Basic Rules: Misconceived Discharge Theory (p. 159-65; 174-78)Sec. 61(a)(12) – Gross Income from cancelation of indebtednessClass Hypo: Clients are going to buy a piece of real estate. Clients go to bank and borrow 125K. On the day they get the check from the bank and sign the note, do they have Gross Income? No, at the time they receive the money, they receive an equal liability. They then use the money to buy property which is secured by a mortgage. Clients both lose their jobs. What happens if the clients don’t pay the loans back? What if bank forgives part of the loan?Loan - $125KForgive - $25KOwe - $100K25K is GI and taxable now under section 61(a)(12). Clients are richer by the amount that they won’t have to pay back.1. Loan Proceeds Are Not Income

Rule – Loan proceeds are not included in GI and loan repayments are not deductible. Rule applies to both recourse (loans on which borrower is personally liable) and non-recourse loans (lender’s only recourse in case of default is against property pledged as security for the loan).

Rationale – Loan proceeds don’t improve one’s economic condition because they are offset by corresponding liability; loan doesn’t increase net worth

Relation to Accounting Method – the rule applies to both cash method and to accrual method taxpayers.

2. True Discharge of Indebtedness A person can have income from the discharge of indebtedness. For tax purposes, one should separate the loan transaction from the transaction in which

proceeds of the loan were used. Tax consequences for the use of the funds should be accounted for independently, according to the requirements of annual accounting. See 165(c)(3)

The leading case on discharge of indebtedness (Kirby) distinguished, instead of rejecting outright, an earlier case (Kerbaugh-Empire) that mistakenly applied a transactional approach, trying the treatment of the loan discharge to a loss on the use of the proceeds.

United States v. Kirby Lumber Co. (1931) – Kirby issued bonds for $12 million for which it received par value. Later in the same year it purchased $1 million (face amount) of same bonds at a price of $862,000 (difference of $138K). Issue – whether this difference is a taxable gain or income of Kirby for the year? Debentures – 1 million. Repayment – 862K (paid 86 cents/dollar to get the million worth of bonds back). When interest rates go up, value of bonds go down. This is like the bank forgiving 138K. Kirby is richer by 138K. Gross income includes gains and profits and income derived from any source whatever. Treasury Reg – If the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year.

Hypo: Clients above didn’t borrow from the bank, they borrowed from an aunt; didn’t lose jobs. Aunt later says, I forgive the $25K debt. Discharge of indebtedness? Yes. Gross income? Probably not, because this would probably be considered a gift. When 61 and 102 may apply, 102 usually trumps. (If anything says something other than section 61, then the other section usually controls.) We have to determine the intent of donor.

3. Relief Provision There are a number of exceptions to 61(a)(12) Insolvent Debtors. Section 108(a)-(b); Insolvent – liabilities exceed assets. 108 is not a

blanket statement – several conditions must be met. Solvent Farmers. Relief provided for insolvent debtors also available to solvent farmers for

“qualified farm indebtedness” (debt incurred in operation of a farm by a person who, during

the 3 preceding taxable years, derived more than 50% of annual gross receipts from farming. See 108(g).

Adjustment of purchase money debt. Section 108(e)(5) provides that the reduction of debt incurred to purchase property and owed to the seller is treated as a reduction in sale price, rather than income to the purchaser.

Student loan forgiveness. Section 108(f)(2) excludes from income any cancellation/repayment of a student loan, provided the cancellation or repayment is contingent upon work for a charitable/educational institution.

Section 108 is an exclusion of Gross Income. No Gross Income if your liabilities are discharged, but 108(a)(3) says you must be insolvent before and after the discharge; but 108(b)(1) reduce attributes from the amount of the discharge debt (b)(2)(E). 2 exceptions. 108(b)(2)(E) – deals with basis reduction

Example – assets = $1,000,000. Liabilities = $1,500,000. One creditor discharges $200,000 of debt. Was the debtor insolvent before and after? Yes (liabilities exceeded assets by $500K before and $300K after). He still has excess debt. This discharge is NOT GI. At the time of this example, the asset has an adjusted basis of $800,000. You must reduce the basis of some asset by the amount of the discharge – 108(b)(2)(E).

Basis is calculated under Section 1017Basis was $800,000. Take away $200,000 discharge of indebtedness. Basis is $600,000. 1001(a) is still going to apply when the asset is ultimately sold. The number for AB is now $600,000 rather than $800,000. Gain is $200K more than it would have been. We have deferred tax consequences until the taxpayer sells the asset.

Sections after §101 trump earlier sections. There are exceptions. 4. Misconceived Discharge Theory

Sometimes gifts are given in exchange for the donee paying the gift tax owed by the donor. If the amount of gift tax paid by the donee exceeds the adjusted basis of the gift; the donor will be taxed on that amount

Example: The client owns property that she wanted to sell/get rid of. Basis - $50K. FMV – 1,000,000. If it’s not a sale, it is a gift. If it is a gift, there is a gift tax. Assume the gift tax is $200K. What are the options?

o Sell a piece of the property worth $200,000. AR = $200K; AB = about 10K bc 200k is 1/5 of a million and 200k is 1/5 of a million. If she does this she will have 190K in taxes – gain is GI

If she did this she would ultimately have less gift tax if she gave the rest away (now a FMV of 800K). She could use the procceds of the sale to pay the gift tax.

The debt follows the farm, so the owner doesn’t have to pay it back. She is not being discharged of a debt because the debt is not disappearing, it is just transferring. She is being relieved of a debt.

Relief of a debt is plugged in to amount realized. o She could mortgage the farm. Worth 1 million, she takes out a loan, secured by a

mortgage for 200K. She can use this loan to pay the gift tax if she gives farm to her grandchildren. What is the basis of property after she takes out the loan? 1 million – no change. She does not have gross income in the amount of the mortgage. Transfer of the farm is subject to the mortage.

Net value of redemption - $800K; grandchildren will have to pay mortgage back Does grandma have an income tax consequence when she makes the gift?

This is partly a gift and partly a sale. She won’t have to pay the mortgage back. She still has money from the mortgage, until she pays the gift tax. Debt of the mortgage has shifted. Is she richer bc she is no longer primarily liable for the debt? Yes, she has $200K cash. She still has a realization under 1001(a).

AR 200,000-AB 50,000 = 150,000 gainDiedrich v. Commissioner

Petitioners made gifts of stock to their children which were subjects to the condition that donees pay the gift tax. Donor’s basis in the transferred stock was $51,073; the gift tax paid by the donees was $62,992. If you fulfill someone else’s obligation to a third party, the original obligator has income because they are made richer. If donee pays the tax, the donor realizes an immediate economic benefit. A donor who makes a gift of property on condition that the donee pay the resulting gift tax realizes taxable income to the extent that the gift taxes paid by donee exceed donor’s AB in the property.

Estate of Weedon v. Commissioner – the donor remains personally liable for the gift tax until it is paid

What if the adjusted basis in example above was $300,000? There is a section that says if a transaction is part sale and part gift, no loss can be

recognized What would the grandchildren’s basis be if grandmas can’t recognize the loss? 300,000 – the

grandchildren have a straight donee basis. Grandma still has the last 200K but she has recognized a los so she has no gains to pay the tax on.

1.0001-1(e)(1) – no loss recognized on the part sale, part giftWhat if $1 million was borrowed against the farm with a fair market value of $1 million?

So far there are no consequences; the $1 million is the loan What does the $1 million do to the basis in the farm? Nothing Your basis is always your cost. Basis in the loan is $1 million is because that is what you

have to pay backWhat if your client didn’t own the farm but borrowed a million to buy it?

Basis in farm would be $1 million – not because she got 1 million loan, but because that’s what she paid

Your basis is in whatever asset you buy with the loan proceeds

F. Transfer of Property Subject to Debt (p. 38, 178-96)5. Transfer of Property Subject to Debt

ACRS – accelerated cost recovery system (depreciation) – intended as an allowance for the decline in the value of the building due to wear and tear and obsolescence. The deduction may not be consistent with economic realty; it is allowed even if in fact there is no decline in the value of property. 1001(a)

Relief of debt – FMV of property received under the definition of amount realized in section 1001(b). See example above. The grandchildren did not get an asset worth $1 million; they only got a gift of excess value of the property over the loan (equity of redemption – 800k – amount of gift).

Another variation of the loan example…o Client borrowed $800,000 and brought property for 1 million; down payment of

200,000. What is his basis? 1 million; the basis of property is its cost, regardless of the source of funds. Allowance for wear and tear – depreciation. Depreciation deduction – the little bit you can take off your income each year (sections 167 and 168). Schedule is 25 years for a $1 million apartment building. 1,000,000/25 = $40,000 = annual depreciation deduction. Our client will get to reduce taxable income by $40K. Depreciation allows you to pay less tax each year. Basis is always changing. Down payment - $200,000. Purchase - $1,000,000. To make up the 800K loan client has to pay 25,000/year for 32 years, plus 10% interest. Payment on principal – 25K; payment on interest $80K; rent $100K. Deprecation $40K. Sale for 1.3 million at end of year 4

Year Principal Interest Rent Outs. Bal. Basis Income Tax

1 25K 80K 100K 775,000 960K2 25K 77,500 100K 750K 920K3 25K 75K 100K 725K 880K4 25K 72,500 100K 700K 840KSection 1016 – adjustments to basis – see also 1016(a)(2) – wear and tear depreciation. The $ you are paying principal with is after tax dollars. 1016 – allowed or allowable – whether you take the depreciation deduction or not, your basis is still reduced, so you might as well take it. Business interest is still deductible – section 163. Loan proceeds considered in basis but not GI. Deduction for interest AND depreciation. 1st year – loss – gross income (80K + 40K – 100K = -20K)Sale: 1,300,000 AR – 840K AB = 460K gain (all taxable in year 5 when building is sold)OR – they assume 700K loan so AR is 600K – No! that is what Crane is arguing. Crane and our client have to pay tax on 700K loan because they didn’t pay it before. Fmv of property received – 700,000. Downpayment – 200K; Depreciation 160K; loan repayment – 100K = 460K gain (these will always add up! When property is increasing in value – appreciation plus depreciation = gain).

Crane v. Commissioner – Crane inherited land and a building from her husband. The property was subject to a non-recourse mortgage, w/ an unpaid balance of $262,042.50 (also the fmv). Basis is fmv at the time of decedent’s death – section 1014(a)(1). Proper basis under 1014 is value of property, undiminished by mortgages thereon, and the correct basis was $262K (before adjustments). The amount of the mortgage is properly included in AR. A mortgagor, not personally liable on the debt, who sells the property subject to the mortgage and for additional consideration, realizes a benefit in the amount of the mortgage as well as the boot. Petitioner realized $257,500 on the sale of this property.

Commissioner v. Tufts – Bayles assumes a 1 million loan on a property with a FMV of 800K. Their adjusted basis when they sell is 840K (1,000,000 AR – 840K AB = 160K gain; AR is 1 million because they have been relieved of a debt.) 1 million is new buyer’s basis (even though fmv was $840K on the date of sale).

The correct way to compute annual depreciation is to compare the present value of anticipated cash flows at the beginning of the taxable year with the present value of such cash flow at the end of that year.

G. Review of Chapter 2 This problem does not have a single numerical right answer Need to know when you don’t have enough information – do more legal research – call my

client and figure out X, Y and Z Do this problem on an annual basis Write down any issues you see in the problem and in any order they come in your mind. Issues 1)Tax consequence of the inheritance? Income? Which value is basis? 325k? or

250K? 2) Tax consequence of replacing the roof? 3) $40K loan he received and paid back 4) deduction for depreciation? Is the building depreciable? Section 167. Did he take the deduction? (call client). 5) is the roof depreciable? Did he take deduction? (call client)

Tax consequences of receiving building – income? Basis?o Answer – tax consequences of receiving building. It is income? NO (section 102(a)).

Would it be gross income otherwise – glenshaw glass case. Basis? FMV at the time of the grandfather’s death – 1014(a). (ignore material in section 1022).

Tax consequences of receiving loan proceeds?o Answer – Generally not taxable. No gross income here because client has to pay back

the loan. There is no section in the Code for this. Under Glenshaw glass, you are richer when you have income. A loan is making you richer.

Tax consequences of repairing roof? Deduct? Add to basis? (how much?)

o Answer for this comes from chapter 6. Most likely answer is that roof is added to basis and then depreciated. Deduct? That depends. If you could deduct it, you wouldn’t add it to basis. It is very likely though it is deductible. It is subject to deprecation. Can you keep the roof as a separate asset? That depends too. Today, you would probably view it as a separate asset. It would have its own depreciation schedule.)

o How much? What is the basis for the roof? $50K (what the roof cost). Basis = cost (section 1012). The basis of an asset is its cost regardless of the source of the funds (Tufts and Crane).

o Roof is depreciable under 167(a). 167(c) – basis for depreciation is 50K cost. Look at schedule in Chapter 6. Let’s say it is 10 years. If you depreciate this evenly over 10 years – you have a $5K depreciation deduction. So, built in year 4. And reduce basis – 1016(a)(2)

Is building depreciable? o 167(a). $325k depreciation (6 or 7k a year). o Is roof depreciable? Yes. Adjust basis §1016(a)(2)

Has client depreciated the building before?o Ask client.

What are the tax consequences of repaying the loan?o Scope here is different because did repay the loan. What happens when you pay it

back? No – repayment of untaxed income. (Interest – did when paid. §163). Tax consequences of sale of building. §1001(a) AR-AB = gain. $400K (amount received) – AB

(first thing we have to figure out how much depreciation did the client take on the building and then on the roof) (we know original basis was $325K and took some depreciation on the building and roof). You would subtract the AB building + AB roof from $400k. The excess would be gain. At least a $25k gain, but definitely more than that (400K - $375K + AB building and roof).

What about getting rent from different renters? §61(a)(5). You don’t add or subtract this from the building’s basis because you aren’t changing anything to the building.

CHAPTER 3 – PROBLEMS OF TIMINGA. Gains and Losses from Investment Property – Introduction (p. 38-9; 211-25; 234-45)Code – 1001(a)-(c), 165(a)-(c); Regs. – 1.1001-1(a)5. Recovery of Cost, Depreciation, and Basis

Origins – timing is one of the biggest issues in tax law and in practice. Taxpayers generally want to defer tax liability. Among the biggest timing issues are those relating to realization and recognition. In general, gain or loss in a change in the value of an asset held by the taxpayer isn’t taken into account under the income tax until a realization event occurs (such as a sale), and even then only in the absence of applicable “non-recognition” statute (one that provides that the gain or loss from the realization event can, at least for the present, be ignored).

6. Entities A. Gains and Losses from Investment in Property1. Legal Origins of the Realization DoctrineEisner v. Macomber

Requires that the gain be realized – must be something more than the mere increase in value. Taxpayer had 2200 shares and was issued an additional 1100 as a stock divided. The stock dividend postpones realization (where cash dividend would be realized immediately). Stock dividend… requires conversion of capital to pay the tax… Stockholder has neither received nor realized… an actual cash dividend is different than a stock dividend.

HOLDING – neither under the 16th amendment nor otherwise has Congress power to tax without appointment a true stock dividend made lawfully and in good faith, or the accumulated profits behind it, as income of the stockholder. The rule of Eisner is now embodied in section 305(a), with limitations in 305(b).

It is always true that:True depreciation 300K+ depreciation allowable 160K= gain realized 460K

Realization means taxable event; asset for cash – clearly realization; asset for asset – less clear, but still realization. Dividing asset in half – clearly not a realization. Anytime there is an exchange close to the middle – you have to decide if there was a realization – question Supreme Court needs to answer in Cottage Savings – how do we decide which side ach transaction is on?

4. Contemporary Understandings of the Realization DoctrineCottage Savings Association v. Commissioner

Losses A financial institution exchanges its interest in one group of residential mortgage loans for

another lender’s interests in a different group of residential mortgage loans… a taxpayer realizes taxable income only if the properties exchanged are materially or essentially different. Properties are different in a sense that is material to the IRC so long as their respective possessors enjoy legal entitlements that are different in kind ro extent. Material difference does not mean value; things to consider – borrowers, secutirty, terms, etc. As long as the property entitlements are not identical, their exchange will allow both the commissioner and the transacting taxpayer easily to fix the appreciated or depreciated values of the property to their tax bases. Like kind exception. 1031; 165(a). There is a realization if… properties exchanged are materially different (even if assets have same fmv and basis).

165 says business losses are a tax deduction, this is a business loss Land for land exchange:

o All are realization transactions because land is materially differento Big transaction so there will always be an ability to pay problem

Congress said that the landowners can be taxed at another time. Tax is not due until there is a recognition. Non-recognition statutes (must be a realization; is there a statute that will allow A and B to pay at another time – 1031)

Decision Tree Do you have a realization? (materially different)

o If yes, do we have to recognize the transactions this year? Recognition. Can we defer it to next year?

If recognition yes, you pay the tax this year. NO deferral. If recognition no, you don’t pay the tax this year. Deferral.

Can’t have non-recognition unless you put a section number next to the word NO. Like §1031.o How can something be materially different and be of like kind? The tolerance for like-

kindness is greater. o Statute is written for real-estate (larger, less liquid).o She may give us an exception (like merchants trading inventory).

B. Express Nonrecognition Provisions (p. 246-53)1. Introduction to Nonrecognition Rules

Realization requirement creates an unintended tax incentive for taxpayers to sell (or be deemed to sell) assets that are worth less than the assets’ basis. For appreciated assets

(worth more than basis), the realization requirement creates an opposite version of the same problem: “lock-in” (disincentive to sell). By holding the appreciated land, you can defer the tax obligation on gain, perhaps ultimately avoid it altogether through bequest, with a stepped up fmv basis under 1014

In some settings, the IRC in effect calls off the realization requirement. Realization inquiry – involves asking whether asking whether something of tax signficance has happened. Recongition inquiry – involves asking whether a specific, statutory non-recognition rule applies to mandate disregard of realization event. Most prominent non-recognition rule in the Code is 1031 – applies to certain exchanges of business or investment property that are held to be “of like kind.”

Non recognition doesn’t mean exclusion; it means no tax now (deferral) Rationale – Consider the following arguments for non-recognition

o Gain should not be recognized if the transaction doesn’t generate cash with which to pay the tax (goal – practicality and administrative feasibility)

o Gain/loss should be recognized if transaction is one in which the gain or loss might be difficult to measure – one in which there is or might be a serious problem of valuation (goal – practicality and administrative feasibility)

o Gain or loss should not be recognized if the nature of the taxpayer’s investment odes not significantly change (goal – fairness)

o Gain should not be recognized (but loss should be) in order to encourage (or avoid discouraging) mobility of capital (goal – economic)

2. Like-Kind Exchangesa. The Like-Kind Requirement

There can be no realization unless the two assets transferred are materially different. How can two things be materially different AND of like kind? Materially different assets (different interest, different borrower, different security, etc.) are smaller than the differences between non like kind assets (generally, any real estate for real estate transaction will be a like kind exchange).

Generally speaking, the rules about personal property are very strict and the rules about real property are very liberal. Section 1031(a)(2) – gives a list of kinds of property that can’t be the subject of a like kind exchange – p.424 in supplement. 1031 applies to both gains and losses shall – if you do not want like kind treatment, do not do a like kind exchange – because you don’t have a choice.

b. Boot and Basis in Like-Kind Exchanges Boot – money, and property other than money, that, under a provision like 1031, is

transferred as part of the like kind exchange but is not like kind property. Transfer of boot will effect basis. Amount of gain recognized is the lesser of amount of gain realized or the amount of the boot. If there is no gain to be recognized, the boot is not taxable; it is the gain that is recognized (and taxable), to the extent of the boot, not the boot itself.

Basis – basis for property received will be same as basis of property relinquished. Calculation of basis when there is boot can be made by following 1031(d); the following principles explain why 1031(d) produces a correct result:

o In a simple exchange of like kind properties with no boot, property received must take on basis of property relinquished so that when property received is disposed of in a

X YBlackacre WhiteacreFMV $25K FMV $25KAB $10K AB $17K

1. X and Y would like to exchange property (purely a real estate for real estate exchange) so 1031 applies, as long as the two people are holding the property for the purposes listed in 1031(a). The gain from dealing in property is realized because the two properties are materially different, but not recognized because the properties are of like kind. 1031(d) – the basis shall be the same as that of the property exchanged (X and Y’s basis in the new property is the same basis in the old property).

2. What is Whiteacre was worth $30K? X transfers Balckacre and exchanges $5K in exchange for Whiteacre. If there is any cash involved at all, then it is recognized if it is a gain (but it would still be a like kind exchange). Y is the client with the tax liability on $5000. 1031(b). Basis – X’s basis in Whiteacre when he receives it is $15,000 (his original basis of 10,000 plus what he additionally paid for Whiteacre; old basis plus cash; 1012 and 1031). Y’s basis in Blackacre is figured according to 1031(d). 17,000 – 5,000 (money) = 12,000 + 5,000 (gain recognized) = 17,000 new basis. DO NOT ASSUME THAT Y’s NEW BASIS will always equal the old basis! 1031(c) - $5000 in a loss won’t require recognition of loss (forbids recognition of loss0. We won’t have hypo where non-like property is anything other than cash.

3. Whiteacre still worth $30K, but Y’s basis is $27,000 instead of $17,000. Nothing has changed on X’s side. X is still transferring Blackacre plus $5,000. Y’s gain recognized is limited to $3,000 according to 1031(b). What Y pays tax on is the lesser of the previous unrealized gain or the cash.

a. Y’s basis = 27,000 - $5,000 (money) = 22,000 + 3,000 (gain recognized) = 25,000 AB in Blackacre

4. X – Blackacre – fmv $25K; AB 10K. Y – Whiteacre – fmv 25K; AB 28K. 1031 isn’t elective; 1031(c) no loss ever recognized on like kind exchange (if you want to recognize loss, don’t do like kind exchange). After exchange, Y will own Blackacre with a $28K basis in it; X will own Whiteacre with a $10K basis in it

5. X side is the same; Y – Whiteacre – fmv $30K, AB – 33K. Y will receive $5K cash and Blackacre in the exchange. Y’s basis in Blackacre would be $28K. 1031(c) says there is still no loss recognized.

X has a 10K basis in Whiteacre. Basis = 33k -5k =28k –0k (no gain or loss recognized) = 28K (1031(d)). (Y has a new unrealized loss that is equal to his old unrealized loss – 3k).

recognition transaction, previously unrealized gain/loss will be recognized (except as that gain/loss is changed by changes in value of property received, subsequent to like kind exchange).

o When gain is recognized because of boot, basis must be increased in amount recognized so that gain will not be taxed again; basis of the like kind property received plus basis of the boot must therefore equal the basis of the original property plus the amount of gain recognized

o Of total basis calculated, a portion equal to FMV of boot must be allocated to that boot, with remainder being allocated to like kind property received.

o If the boot is paid, rather than received, amount of boot is added to basis A – original basis; B – amount of gain recognized; C – total basis to be allocated between the

like kind property received and the boot; D – portion of basis allocated to the boot (which always receives a basis equal to its FMV; so D=FMV of boot); E – the new, or substituted, basis of the like kind property received. A+B=C C-D=E

o Thus, if there is no boot (B and D are both zero), the like kind property received will have the same basis as the property surrendered (E = A)

Non recognition – effect is to postpone tax payment in case of unrecognized gains, and to accelerate tax payment in the case of unrecognized losses. Non recognition transactions can roughly be divided into three categories:

o Continuity of investment cases, where non recognition normally applies to gains and losses alike

o Hardship situations, where non recognition is usually confined to gains

D. Transfer Incident to Marriage and Divorce – Introduction; Property Settlements (p. 310-20)1. Introduction

Transfers incident to marriage and divorce raise income and deduction issues. There are complex rules distinguishing between alimony and other types of transfers that are not deductible by the payor and not taxable to the payee.

Property settlements – section 10412. Property Settlements

a. Transfer Incident to a Divorce or Separation AgreementUnited States v. Davis Marital discharge – fmv of 83K. Basis in stock – 75K. Husband (davis) has a gain of 8k

(83AR – 75 AB = 8 gain). Congress came up with 1041 for this type of situation. A) no gain or loss shall be recognized … if the transfer is incident to the divorce. B) property shall be treated as acquired by the transferee by gift and the basis of the transferee in the property shall be the AB of the transferor. Don’t pay attention to (b)(1); just (b)(2)! Donee gets donor’s basis no matter how high/low it is compared to the FMV. Donee recognizes the gain or loss. Mrs. Davis’ basis would be 75K. (Means Mr. Davis would not pay the tax when the property is transferred but Mrs. Davis would pay tax when she sells.) 1041 Overrules Davis.

HYPO – A owes B money on a loan made several years ago. B says he will discharge the loan; instead of requiring you to pay me cash, I will take the boat you have in your backyard. Boat has a fmv of 25K; value of the loan was 25K. This is property satisfying a debt rather than cash. Does A have GI? Loans don’t generate GI when you receive them or when you pay them off. Whether A has GI depends on what his basis is in the boat. If A’s basis in the boat is 15K he has GI in the amount of 10K and it’s taxable. Why? 25K AR – 15K AB = 10K gain. 25K is the value of the discharge. Variation on Davis.

Congress altered result in Davis and simplified law by adopting 1041 – provides that no gain/loss shall be recognized on transfers of property between spouses or incident to divorce

o 1041 works together with the alimony rule – 71(b)(1)o Alimony is deductible by the payor and included in the income of the payeeo Results are that transfer of property, other than cash, incident to divorce;

Does not result in the recognition of gain and Doesn’t give rise to deduction by transferor or income to transferee

b. Antenuptial SettlementsFarid-Es-Sultaneh v. Commissioner F argues $10 is her 1012 cost (basis) because they had a bilateral agreement – stock for

property rights. F’s inchoate interest in the property of her husband greatly exceeded the value of stock transferred to her. She performed the contract under the terms of which stock was transferred to her and held shares not as donee but as purchaser for fair consideration – basis $10, gain $9/share. Antenuptial means before marriage

1041 not enacted at the time of the case. 1041 says spouse or former spouse – but usually getting married is a condition precedent to a transfer as part of a prenuptial agreement. If you provide in prenuptial agreement that the transfer is to take place before marriage, 1041 doesn’t apply. If the marriage is the precondition to the transfer, 1041 applies. Once they are spouses/former spouses, 1041 will apply.

E. Same – Alimony and Child Support (p. 320-28)a. The Basic Scheme

Alimony is taxable to payee and deductible by payor, while child support and property settlements are not taxable to payee and are not deductible by payor. Section 71(a); 215; 62(a)(10) (71 – usually called income shifting or splitting)

Alimony/separate maintenance agreements must meet certain requirements in section 71o The payment must be in cash – 71(b)(1)o The payment must be received under an instrument of divorce or separate

maintenance – 71(b)(1)(A), 71(b)(2)o The parties must not have agreed that the payment will be nontaxable to the payee

and nondeductible to the payor under 215o The parties must not be members of the same household – 71(b)(1)(C)o The payments can’t continue after the death of payee spouse – 71(b)(1)(D)o The payments must not be for child support – 71(c)

71(f) provides that only payments that are substantially equal for the first three years will be treated as alimony. If the payments in the first year exceed the average payments in the second and third years by more than 15K, the payments are initially treated as alimony but the excess amounts are recaptured (the payor must include the excess in income) in the third year

Gould v. Gould – alimony is not encompassed by the phrase “gains or profits and income derived from any source whatever”

Tax incentive: potential gain from transforming payment from nondeductible child support or property settlement into deductible alimony can be significant

o Example – TI of $50K or less – rate = 10%. TI of more than %50K – rate on excess = 35%

o Person 1 – TI = 100K for the years immediately following the divorce. Tax = $5K + 35% of 50K = 22500

o Person 2 – TI = 0 for the years immediately following the divorce Section 71 allows these parties to make a written agreement that says person 1 agrees to

pay person 2 30K year for maintenance. This will change their taxable income. Gives person 1 a deduction for 30K (he pays taxes only on 70K), person 2 will have GI of 30K.

Person 1 = $5K + 35% of 20K = 12,000 (reduced by more than 10k)

Person 2 = 3000 = taxb. The Rulesc. Policy QuestionsProblems on P. 323 and 324If you jump through all the hoops, you get the result you want. That is why you decide the result you want first.

1) Max and Winifred divorced. Did not make any arrangements for alimony. Now, Max wants to make them. Winifred orally agrees to pay $2K a month. Not part about a divorce decree (didn’t happen under a divorce or a separation instrument). A telephone call is not a divorce or separation instrument under §71(b)(1)(A) or (b)(2). Winifred isn’t going to get a deduction and Max cannot get gross income.

a. Later on the parties can agree to alter and make it part of a divorce or separation instrument.

2) Spouses (Manuel and Wanda). Manuel is because he was a successful surgeon. Wanda starts law school… finishes her first year. Manuel offers to pay Wanda $60K the first two years and $5K the next two years after that.

a. Yr 1 - $60K. Yr 2 - $60K. Yr 3 - $5K. Yr 4 - $5K.b. Now, have a payment that qualifies under section 71(b). In year one, it is gross income to

wanda and deduction to manuel. Same for years two-four.c. Congress doesn’t like this. Year one and two are front-loading. It allows the transferor to

dump a lot of income on the transferee spouse. d. You do not need to know the front-loading formula. You do need to know the

consequences. Refer to §71(f). All of the action is in year three. If the payments are substantially greater (more than $15K – for one year only) than in year three, take the deductions that Manuel got in years one and two and give it back to him in year three. Excess GI to M, Deduction to W. Wanda probably loses the $100K deduction because she probably just made like $5K that year.

e. Yr 1 - $40K. Yr 2 - $40K. Yr 3 - $40K. Yr 4 - $10K. No front loading here. We don’t care about the difference between year three and four. As long as first three years are close together, you don’t have to do a §71(f).

3) Wanda has a father, Fred who is dependent. They have an agreement that if Wanda dies the money will go to Fred. Manuel pays Fred after Wanda’s death. Violated one of the paragraphs under §71(b)(1)(D). Required to stop the alimony payments after the spouse dies. Spouses are required to support each other under state law.

a. In the first year when he pays $60K to Wanda… the $60K is not alimony for federal tax purposes. Because that section says it is not §71(b)(1)(D). Not a deduction for Fred. Not gross income for Wanda.

§71(c)(1) – in general, subsection (a) shall not apply to that part of any payment which the terms of the divorce or separation instrument fix as a sum which is payable for the support of children of the payor spouse. This is a behavior modification statute.

This is not as strange as it looks because elsewhere parents are allowed a deduction for each child he/she supports. §§ 151, 152 – personal exemptions for dependents. $3500/child/yr. This is a flat amount. It doesn’t matter if you are spending more. Congress wanted to be consistent here – married couples with kids deduct the same amount as separated couples with kids.

If you are paying child support, you get a deduction under §§ 151 and 152 Let’s say you write a separation agreement where the payor spouse has to pay $3000 a month

until may, 2020 (the youngest child reaches 18). This sentence will be considered child support. Problem 4 (p. 324) – Mike and Wilma have a son, Carlos, who is two years old. Mike is a successful lawyer. Wilma was also a successful lawyer, but quit practice when Carlos was born. Mike and Wilma

have decided to divorce. Mike agreed to pay Wilma $40,000 a year for ten years or until Carlos dies. Will this $40,000 be considered alimony? No. It is considered child support and falls under §71(c). Not deductible. If Mike wants the deduction, he has to cut out the part “for 10 years or until Carlos dies.” If it just said $40K a year, it is alimony not child support. Hess would add “until Wilma dies.” One situation where Hess doesn’t know is if it said “Wilma gets $40K a year for 10 years or until she dies.” A situation which would work would be “10 years or whenever she goes back to work.”

o The only thing that matters is the divorce decree. So, if you represent the payee spouse, it is in your client’s interest to have the payor spouse to pay it as alimony.

Question 5 – p. 324 Nancy and John get divorced. Nancy is required to pay John spousal support (alimony) of $10K a

year. When the payment becomes due she doesn’t have cash so she gives it in stock. She is not allowed to do this under §71(b)(1)… has to be cash. So, when she gave the stock, she wasn’t technically paying alimony. No deduction under §71(b)(1). It would fall under §1041(a)(2) – no gain or loss shall be recognized on a transfer of property from an individual to a former spouse, but only if the transfer is incident to the divorce. Under §1041(c), incident to divorce is related to the cessation of the marriage.

We’ve said that Nancy gets no deduction. John doesn’t pay income tax on it because it didn’t fall under §71(b) It is a transfer between former spouses. No tax today and no deduction to anybody day. John gets

a $1000 basis in the stock. In the future, he will pay tax on the difference between the value of the stock and the $1000 basis.

If Nancy wants to take the $1000 deduction, tell her to sell the stock. She’ll have to pay tax on the gain though before she pays John.

d. The Tax Incentivee. A Final Question4. Child Support Obligations in Default

Child support is not deductible by the payor and is not taxed to the payee (usually the custodial parent)

Diez-Arguelles v. Commissioner – non-business bad debts are deductible only to the extent the taxpayer’s basis in the debts under section 166. Taxpayer here had no basis in the debts (basis of $0). Arrangements in child support payment were not deductible.

Section 71(a) provides that alimony/separate maintenance shall be included in wife’s GI. 215(a) allows corresponding deduction to husband for payments includable by the wife. Section 682 extends the statutory scheme to trust arrangements by excluding from the husband’s income, and including in wife’s income, amounts received from an alimony trust. Husband is treated as a conduit for GI that legally belongs to wife under the divorce decree. Section 62(a)(10) provides that alimony payments made by a husband shall be deducted from his GI in computing his AGI: deduction is permitted even if husband does not elect to itemize his personal expenses, i.e., just as if payments were excluded from his income to begin with

Theoretical Issues (p. 328)a. Charlie Carpenter last year earned $35K. This year he earned $20K and built a house to rent to

others. He used $30K of savings to buy land and materials. FMV of the house was $45K.a. Yr 1 - $35K GI comp. for svcs.b. Yr 2 - $20K GI comp. for svcs. [$15K self-performed services – no tax – we like self-

sufficient people] $30K spent on materials and land is his basis in the house. The fact that the house is worth $45K does nothing because there is NO REALIZATION.

b. Tom Trucker earned $35K driving a truck. He took $30K of savings from earlier years and $15K of this year’s earnings and bought a house for $45K.

a. This yr – GI - $35K. AB house = $45K.

c. Ann Accountant earned $35K last year. This year she earned $20K and went to law school. a. Last yr – GI $35Kb. This yr – GI $20K. She can’t take a tax deduction for the labor she is putting into law

school. It is a personal expense. d. Perry Player – future earnings expected to be $30 million. Until he earns income, he doesn’t have

any. Has a basis of $0K. F. Review of Chapter 3

CHAPTER 4 – PERSONAL DEDUCTIONS, EXEMPTIONS AND CREDITSA. Introduction; Charitable Contributions (p. 351-55, 381-82, 383-400)1. The Mechanics of Personal Deductions

Personal deductions are subtracted from GI to arrive at TI. Personal deductions include itemized deductions in addition to alimony. Individuals may elect to give up itemized deductions (other than alimony) and claim the standard deduction (amount varies with taxpayer and annually 63(c)). In addition, all taxpayers are entitled to a personal exemption deduction for themselves and for each of their dependents – section 151; benefits of personal exemption are phased out as adjusted gross income rises about certain amounts. Under section 68, itemized deductions will be reduced by 3% of the excess of adjusted gross income over the threshold amount.

o Loss can’t exceed 80% of otherwise allowable itemized deductions and deductions allowable for medical care, casualty losses, and investment interest expense are not subject to the limitation.

o Congress has enacted a gradual repeal of phaseouts for both personal exemptions and itemized deductions (to be fully restored in 2011)

You can get a standard deduction no matter how many dependency deductions you get/take Personal deductions have nothing to do with production of income, section 104(a)(2). They

are sometimes labeled upside down subsidies – subsidies that benefit most those who need them least. Provision that imposes a flat rate tax on a broader base – namely Alternative Minimum Tax. AMT, in section 55. AMT does not affect most taxpayers; when it applies, it affects tax liability in a quite arbitrary fashion.

2. The Rationale for Personal DeductionsD. Charitable Contributions1. Overview

Individuals and corporations can claim as itemized deductions any “charitable contribution… payment of which is made within the taxable year.” 170(a)(1). Charitable contribution is defined to be a contribution or gift to or for the use of certain enumerated eligible donees; 170(c). 170 limits deductions to 50% of taxpayers contributed base (which is generally adjusted gross income). Many organizations that are tax exempt under 501, don’t meet the requirements of 170(c). 527 provides separate rules for tax treatment of political organizations. If an organization engages in lobbying it may lose tax exempt status as to contributions. 170 – deduction; 501(c)(3) – definition of charitable organization. Must keep records! (This is difference from standard deduction; you have to prove it). Itemized deductions always have one thing in common – more valuable to high bracket taxpayers than low bracket taxpayers.

2. Contributions of Capital Gain Property When a taxpayer makes a gift of property whose sale would produce long term capital gain,

the amount allowed as a deduction is full FMV of the property. The gift of property itself is more advantageous than sale of the property followed by a gift of the proceeds.

3. Policy 4 kinds of contributions: contribution to: a charity, a church, a church required by the religion,

and a fund. The charitable deduction reduces tax revenues by billions of dollars a year.

4. Gifts with Private Objectives or Benefits Ottawa donated land to government so government would develop roads. Ottawa claimed

deduction in the amount of FMV of land donated – 415K. Government didn’t allow deduction because the donation provided a substantial benefit to donor. Singer v. US – receipt of benefits by donor need not always preclude a charitable benefit. No deduction – can figure donation in basis when land is sold.

The effect of the government victory was twofold:o Taxpayer forced to defer any tax benefit for what might be many yearso The eventual tax benefit would be limited to the basis of the contributed property,

rather than on the fair market value of the contributed property5. More on Private Benefits

Quid Pro Quo Contributions – amount of any non business related deduction for a charitable contribution is limited to excess of the payment of the charity over value of benefit received by donor. In determining the amount of the reduction, it is the value to the donor that counts. 6115

6. Overvaluation of Contributed Property Most common with works of art. Isbell v. Commissioner; 170(e)(1)(B). Tax reform act of 1984

imposed a requirement that Treasury issue regulations for substantiation of the amount of the deduction for gifts of property with value greater than 5K. To meet substantiation requirement, donor must obtain qualified appraisal and signed appraisal summary.

The Special Case of Collegiate Athletics – 170(a) – allows a deduction for 80% of any amount paid to an institution of higher learning if the deduction would be allowable but for the fact that the taxpayer receives (directly or indirectly) as a result of paying such amount the right to purchase tickets for seating at an athletic event in an athletic stadium of such institutionVoluntariness – Lombardo v. Commissioner – the taxpayer made the payments in order to avoid going to prison – no deductionWhat is Charitable? Bob Jones University v. US – Can an institution be considered charitable if they practice race discrimination? NO. The racial policies of the schools violate clearly defined public policy. To qualify for tax exemption pursuant to 501(c)(3), an institution must show:1) that it falls within one of the eight categories expressly set forth in that section2) that its activity is not contrary to settled public policy7805 – Congress has power to make needful rules and regulations for implementation of the tax code

Definition of terms – 501(c)(3) Administrative rules – system of classification

501(c)(3) is disjunctive – does not say “and,” it says “or.” Hess thinks it seems like the Court read the “or” out of the statute in Bob Jones case. Congress has not since amended the statute to change the “or” to an “and.” Where do you draw the line? Hess’ undergrad school was all women but considered a public charity. Most education/religious institutions are considered a 501(c)(3) charity.You must ask two questions:* is this truly a contribution?* is the donee performing a public service?B. Interest (p. 401-04)1. Business or investment interest – interest incurred in a trade or business or for the production of income – is a proper adjustment in arriving at net income and has always been allowed as a deduction. 163(a), (d)2. Personal interest on a home mortgage loan is deductible if it is “qualified residence interest.” 163(d)(2). All other interest not incurred for business or investment purposes is nondeductible “personal interest.” 163(h)(2).3. “Qualified residence interest” falls in one of two categories:

Acquisition indebtedness – debt incurred to buy, build, or improve a personal residence, and which is secured by the residence

o 163(h)(3)(B)o $1 million limit

home equity indebtedness – any debt secured by a personal residenceo 163(h)(3)(C)o 100k limit, but not in excess of fmv of residence (may exceed basis)

4. National behavior modification deductions: (personal deductions) home mortgage, education loans, not allowing credit card interest to be deducted5. Business deductions that are accurate reflection of income: investment loan, business loan6. Home mortgage interest deductions favor high bracket taxpayers, residential rent is never deductible7. policy issues: interest on personal indebtedness is a cost of consuming sooner rather than later… a deduction for consumer interest allows consumers to avoid the tax that would apply if funds were invested in assets producing taxable income. Favorable treatment of loans secured by personal residences are justified on the ground that encouraging home ownership is a personal policy goal8. Tracing – the differing treatment on personal and business loans raises a number of difficult tracing issues. Treasury Regulations 1.163-8T – interest on a loan that is used for personal purposes is characterized as a personal interest; the fact that the loan may be secured by business property is irrelevant.9. What is “interest?” If loan is personal, expenses other than interest will normally be nondeductible. Points (fees for making a loan measured by a % of total loan) on home loans are interest paid if paid “for the use of money.” 461(g)(2). Share Appreciation Mortgage (SAM) – borrower pays interest at a rate below the rate that would be charged on a normal loan and agrees in addition to pay to lender a portion of any apprication in the value of the house on sale or at the end of some specified rights to occupy premises, obligation to pay taxes and other costs of ownership, and the right to sell, improve, etc.)10. interest on student loans – 221 allows a deduction for interest on indebtedness used to pay higher education expenses of taxpayer, taxpayer’s spouse, or a dependent of taxpayer amount deductible is $2500. This is a deduction section. A deduction and a credit are not the same thing (child care is a credit).11. Chirelstin – interest is subject to a fourfold classification under the Code:

1. interest incurred in the conduct of a trade or business2. investment interest 3. interest taken into account in determining a taxpayer’s income or loss from a so called

passive activity4. consumer interest

12. Various Credits – section 22 provides a credit for retirement income; section 23 provides a credit for adoption expenses up to $5000 (6K for adoption of child with special needs); section 24 allows each taxpayer a credit for each dependent child under age 17. (Child is defined under 152 to include certain other relatives living with taxpayer). The credit is refundable under limited circumstances. Many individual credits are intended to provide relief for low income families and are phased out as income rises above specified levels. An unwanted but unavoidable consequence is often a very high “tax” rate (since the reduction of a credit is functionally equivalent to the imposition of a tax).

CHAPTER 5 – ALLOWANCES FOR MIXED BUSINESS AND PERSONAL OUTLAYSA. Introduction; Expenses for Child Care and Commuting (p. 419-21, 477-86, 487-93)

A. General

1. There are two basic provisions under which individuals may claim deductions for expenses that may be thought of as the cost of generating income:

a. 162(a) – the deduction for ordinary and necessary expenses paid or incurred … in carrying on any trade or business

b. 212 – covers expenses of generating income from sources other than a trade or business (not allowed under AMT)

2. Section 262 – no deduction shall be allowed for personal, living, or family expenses3. Section 67 provides that certain of the itemized deductions are allowable only to the extent

that in the aggregate they exceed 2% of AGI. Section 7 has the effect of disallowing deductions for expenses with a significant personal element

4. Section 62(a)(19) allows deduction above the line (arriving at gross income) for attorney fees and court costs for claims of discrimination under civil rights law and others

5. Section 280(a) – severely limits deductions for vacation homes and home officesB. Child Care Expenses

1. Case that follows arose before the adoption of statutory provisions allowing a credit for certain child and household care expenses of working parents. Case is still controlling on the question of deductibility of child care expenses… this is a credit, not a deduction. The credit that phases out as taxpayer’s adjusted gross income gets higher.

2. Smith v. Commissioner (1940) – petitioners tried to claim deduction for money spent on nannies for their kids because both parents were employed. Commissioner disallowed deduction. The care of children is a personal concern.

3. Congressional response: section 21 – credits % of amount spent for household services; percentage used in determining amount of credit declines as income rises. This is a credit, not a deduction (refundable credit)! Credit is a subtraction from tax liability (GI – deductions = TI x tax rate = tax liability – tax credit). Does not affect tax rate. Credits are more valuable to low income tax payers.

a. 21(a)(2) – if you are a low income taxpayer, you multiply child care expenses by 35% and credit for that. 35% goes down by 1% for each $2000 of AGI you have; but never goes below 20%.

b. Justification – national behavior modification not accurate reflection of incomeSection 129 – permits employer to make available to employees, free of tax, up to 5K/year for child care expense through a dependent child care assistance program, DCAPSection 21(c)- the amount of child care expenses that can be used to calculate the section 21 tax credit is reduced by amounts paid through a DCAP and excluded under section 129C. Commuting Expenses

1. Seen as being on the middle of the line between personal expenses and business expenses. You can’t really do your job from home v. you choose where you live.

2. Section 162(a)(2) – there shall be allowed as a deduction all ordinary and necessary expense – traveling expenses while away from home in pursuit of trade/business

3. Most courts/regulations have held that 162(a)(2) doesn’t include commuting expense. Everyone has to incur this expense in order to make income. Giving no one this deduction is same as giving it to everyone – just makes computations easier. (not true that this is really equal – some people work from home, some people live farther away, etc. Courts say where you live is a personal choice.)

4. This section does not tell us what difference is between a commuting expense and what is allowed as a deduction – traveling expense

a. To make this distinction, you must define the word “home”b. Hess thinks “home” is principal place of business (you get to work and realize you

have to be somewhere else to do your job – traveling expense)

5. Commissioner v. Flowers – 162(a)(2) allows deduction for income tax purposes of traveling expenses while away from home in pursuit of trade or business. 3 conditions must be satisfied before deductions is made under 162(a)(2):

a. Reasonable and necessary traveling expenseb. Incurred while away from homec. Incurred in the pursuit of business

Question of fact. Added costs in issue were unnecessary/inappropriate to the development of the railroad’s business as were his personal/living costs on Jackson. The exigencies of business rather than the personal conveniences and necessities of the traveler must be the motivating factors. (Hess thinks Flowers should have argued that Jackson was his principal place of business.)

Example – football player in Miami comes to Knoxville to pursue real estate career during off season. Courts have said coming to Knoxville in pursuit of a trade or business. If football player is at home in Miami, he can deduct cost of traveling from Miami to Knoxville, apt and meals in Knoxville, cost of parking car in Knoxville. All expenses of the secondary place of business are deductible. Common example – visiting professor –all the expenses of visiting are deductible. Travel expenses include:

Travel expense include – transportation, meals, lodging “sleep or rest rule” – you can’t take a deduction for meals and lodging unless you are away

from home long enough to require sleep or rest you can’t take a deduction for meals if you come back in one day. Theory – eating is a

personal expense that would be incurred anywayIf you don’t have a home to be away from, you are not traveling away from home, so you have no deductions. Common example – truck drivers. *Reimbursed expenses not deductible by person reimbursed – EVER!

6. Hantzis v. Commissioner – where a taxpayer resides and works at a single location, he is home. “While away from home” requirement has to be construed in light of the requirement that the expense be the result of business exigencies. The ultimate allowance or disallowance of a deduction is a function of the court’s assessment of the reason for the taxpayer’s maintenance of two homes:

a. If reason is personal, home is place of employment and deduction deniedb. If reason is business exigencies, home is residence and deduction allowedH’s trade or business didn’t require her to maintain a home in Boston or NY. For the purpose of 162(a)(2), NY was her principal place of business so she was not away from home. She had no principal place of business in Boston (husband did).

This present two questions:1. if she clerked for firm in Boston while in school at Harvard, would she have principal

place of business in Boston to be able to take deductions for traveling away from home to work in NY? Probably

2. question of 2 career family: 2 people both gainfully employed , working ear round in different cities. Hess thinks this will be legislated soon – amend to section 162 that will allow deduction for these expenses

7. 162(a) – limits temporary jobs to those lasting a year or less. A person who takes a temporary job is allowed to deduct travel/living costs – Peruifoy v. Commissioner

8. Moving expenses – section 217 allows deduction for moving expenses of a taxpayer who takes a new job, if the new job would add at least 50 miles to his commute and in the year following the move, taxpayer work sat least 39 weeks at the new job. Deductions under 217 aren’t subject to the 2% threshold found in 67(b)(6)

CHAPTER 6 – DEDUCTIONS FOR THE COST OF EARNING INCOME

A. Current Expenses v. Capital Expenditures; Repair and Maintenance Expenses (p. 36-37; 511-38) Salary expenses are usually seen as current cost of doing business are deductible under

section 162 against current income. A company must capitalize, rather than currently deduct, the amount it pays for anew factory

Encyclopedia Britannica v. Commissioner – section 162(a) allows deduction of all ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade/business. Section 263(a) forbids immediate deduction of capital expenditures even if they are ordinary and necessary business expense. Cost of purchasing a completed manuscript from an unrelated company must be capitalized and amortized against sales; each set of the dictionary has basis. Issue here isn’t whether, but when; cost is a business cost. This isn’t taxpayer friendly, but is correct on accurate reflection of income terms. Hess thinks this opinion gives best distinction – better than a Hornbook

Hess – accurate reflection of income demands that when you purchase an asset, you add all the costs of creating the asset to the basis of the asset. Here, asset purchased is inventory purchased for resale. Inventory is NEVER depreciable.

263(a) – self created assetso when you purchase something whole, you know what you paid ito when you create something yourself, it is a lot more complicated to allocate price.

Accuracy is more important than simplicityo uniform capitalization – unicap – if you represent manufacturer of goods there will be a

bookkeeping problem in allocation of goods/basis; usually accountant will do this. We need to know it’s there and can be a headache – it’s result of ideological battle between 2 characteristics of a good tax – be accurate and issue costly rules or write large (estimate) and be easier.

o All of the costs that are directly related to production is allocable to basis rather than being an ordinary and necessary business expense

The object of 162 and 263, read together, is to match up expenditures with the income they generate. Basic goal – to provide a true reflection of income

If you hire a carpenter to build a tree house that you plan to rent out, his wage is a capital expenditure to you – Commissioner v. Idaho Power Co. – 263(A)

Revenue Ruling 85-82: May a taxpayer currently deduct, under 162, the portion of purchase price of farmland that is allocable to growing crops? May not deduct in 1982 the portion of purchase price allocable to growing crops, but may take into account such portion arriving at net farm profit/loss for 1983 (year in which growing crops are sold)

Not on Uniform Capitalization Rules (263(a)): cost of producing inventory and other self created assets, such as in house production of manuscript, must be capitalized. These costs include salaries of people writing manuscript and indirect expenses such as the allocable share of salaries of supervisory and administrative people. 263A rules are complicated and require many different determinations.

Repair and Maintenance Midland Empire Packing Co. v. Commissioner – Whether expenditure for a concrete limiting

in petitioner’s basement to oil proof it is deductible as ordinary/necessary expense under 162(a)? Basement wasn’t enlarged by this work, nor did it make it more desirable. Repairs served to keep property in operating condition over its probable useful life for the purpose for which it was used. Repair and is deductible as ordinary/necessary business expense. Whether something is ordinary/necessary business expense is question of fact.

o Separate asset; identifiable function – useful life is not the same as building – this would be capital asset – not immediately deductible – depreciable over useful life. This group eliminates a lot of things that could be thought as of as repairs (repairs are necessary/ordinary business expenses and therefore deductible immediately).

o If you are doing something to an asset, besides purchasing a new one, will the asset be able to do something new (or can it only do what it did before it was broken)? If no new function – repair; if new function (or better than it was before it was broken) – new asset.

If deduction for a loss is allowed, deduction for any repair to restore property to preloss condition must be declined. Mt Morris Drive In v. Commissioner – cost of drainage system has to be capitalized since need for it was foreseeable and part of the process of completing taxpayer’s initial investment for original intended use.

Revenue ruling 94-38: are costs incurred to clean up land and treat water that a taxpayer contaminated with hazardous waste from its business deductible by a taxpayer as a business expense under 162, or must they be capitalized under 263? Costs incurred by X to evaluate and remediate its soil and water contamination constitute ordinary and necessary business expenses deductible under 162.

Northwest Corp and Subsidiaries v. Comm’r – whether costs of removing asbestos materials are currently deductible under 162 or must be capitalized under 263 as part of a general plan of rehabilitation? Cost of removing asbestos containing materials must be capitablized because they were part of general plan or rehab and renovation that improved the building; depreciable rather than immediately deductible. If ONLY asbestos removal was done, it would probably be immediately deductible as a necessary and ordinary business expense

Hess guidelines:o If it’s expensive: improvement. If it’s cheap: immediately deductibleo Question of fact that require analysis – this will be an essay question!o What she wants us to do is write a jury instruction that tells the jury why this should be

a repair – or tell your client why it can’t be.Inventory Accounting

If a taxpayer buys machinery that will produce income over several years, its costs must be capitalized and depreciated over such period

Use of authorized methods of inventory accounting is required in every situation where production, purchase, or sale of merchandise is an income producing factor (except farming). Purchases are added to inventory and their cost is treated as if it were a capital expenditure; ultimate disposition of the goods and minerals, as reflected in changes in the quantity of physical goods in inventory after taking account of additions to it during the year, is treated as the event giving rise to a deduction for that cost.

Cost of Goods sold. Gross profit from business operation is found by deducting cost of goods sold from gross receipts. Cost of goods sold is found by adding the beginning inventory to the cost of goods purchased or produced during the year and subtracting the total inventory still on hand at the end of the year.

B. Rent v. Installment Purchase; Goodwill; “Ordinary and Necessary,” Reasonable Compensation (p. 541-58)

1. Starr’s Estate v. Comm’r – installation of sprinkler system. Lessee should not suffer the pains of a loss for what really was paid for the use of another’s money, even though for tax purposes his lease collapsed. Manufacturer contained no significant residual interest; this was a conditional sale despite title never actually passing

2. Taxpayer’s objective was to bunch as much as possible in the early years of the use of the asset. At present because of accelerated cost recovery system, the kind of transaction is starr’s estate would offer little advantage over ownership. If transaction is treated as installment purchase, taxpayer’s entitled to interest deduction as well as depreciation

Goodwill and other assets1. Welch v. Helvering – reputation/learning are akin to capital assets, like goodwill of old

partnership (nor ordinary expense of operation of business). Good will has indefinite useful life (assets that have nondeterminate useful life aren’t depreciable). It’s business expense but must

be added to basis (not immediately deductible). Addition to basis will reduce gain when you sell but no affect on your tax until then. It’s business asset (reputation for being honest business man), but has useful life of more than 1 year.

2. Section 197 – permits an amortization over 15 years to purchased good willa. Would not apply to the goodwill in the above caseb. Would basis in your own labor and your own good reputation is zero

3. To be deductible under 162(a), an expenditure must be incurred in carrying on a trade or business, And must qualify as ordinary and necessary

4. Business expenses of employees, including cost of employment-related education, can be deducted only to the extent that they exceed 2% of AGI (section 67)

Ordinary and necessary1. Extraordinary behavior – Gilliam v. Commissioner – tax court memorandum opinion – means

no new law, just old law is being applied to the facts. Gilliam’s trip to Memphis in furtherance of his trade or businesses. His expenses for legal fees and claim settlement are not ordinary expenses of his trades or businesses. Deputy v. DuPont – ordinary has the connotation of normal, usual, or customary. Petitioners bear the burden of proving entitlement to a deduction under 162.

2. Necessary doesn’t mean that you will lose your business if you do not incur this expense. Aspects to ordinary and necessary:

* reasonable business person would incur this expense* relationship of the expense to the business (Gilliam)

3. Friedman v. Delany – it is no part of lawyer’s business to take on personal obligation to make payments which should come from his client, unless in pursuance of a previous understanding to do so. Pepper v. Commissioner – payment on client’s behalf was deductible.4. Reasonable Compensation: 162(a)(1) provides for deduction of “reasonable allowance for salaries/other compensation for personal services actually rendered”

Leaves the potential for an employee paying tax on more salary than the employer can deduct (actual v. reasonable)

Every business gets 162 deductions (business and corporation arent’ synonymous) If business is run as corporation, you have additional taxpayer; corporation pays tax and files

tax return separate from those of its shareholders. Shareholders can have tax consequence (dividends). Corporation does not get deduction for dividends (gross income to recipient but no tax consequence to transferor)

A corporation is a business. It does have ordinary and necessary business expense even though dividends are not one of them (i.e. salaries). Incentive to make money paid to SH look more like salary than dividend

5. section 61(a) only says compensation – not reasonable (inclusion section for Gross Income). All compensation is taxable but only reasonable compensation is deductible. If compensation is unreasonably high, you pay tax on 100%; your employer gets a deduction only on what is reasonable. Reasonableness is question of fact.

6. Closely held corp common problem – what purports to be deductible salary is in fact non deductible dividend (disguised dividend) only changes tax consequences to corporation

a. Employee has to pay tax on dividends and salaryb. Employer can deduct salary but no dividends

7. 162(m) – publicly held corporations can’t deduct more than $1 million/year in pay to a CEO or any other of its four highest paid employees (deduction limit does not apply to performance based compensation)

C. Depreciation (p. 37-38, 565-71, 576-79, 588-97)1. Economic concept underlying depreciation – there should be offset against revenues for cost of “wasting” assets used for production of those revenues but have a life extending beyond current tax year. Allowing deduction of full cost in first year would result in understatement of income. Allowing

no deduction until year in which asset is disposed of would result in overstatement of income until year of disposition and, it that year, an understatement. Section 167 and 1682. The depreciation provisions are designed to overstate the decline in value of business property, and, in doing so, understate taxable income. 3. Any depreciation system resolves around the spreading, or allocation, of cost over tine and has three elements:

1. the determination of useful life2. taking account of salvage value

a. usually assumed to be zero3. application of method of allocating the cost, in excess of salvage value, over useful life

a. straight-line method – equal porition of the total cost of the asset is allocated to each year.

b. Accelerated methods – greater amounts are allocated to the earlier years. The advantage is deferral

c. Declining balance method – the straight-line percentage is determined and then this percentage is increased by a specific factor. At some point this method produces a deduction less than would be produced by straight-line; and it never reaches zero

d. Decelerated method – deductions are lower in the earlier yearse. Income Forecast method – the current year’s depreciation deduction is derived from a

projection of future income4. Section 169 allows rapid amoritization for certain investments and current deductions for

various other investments (174). The basis is reduced if depreciation is allowable, even if the deduction is not taken. 1016(a)(2)

5. Any gain on disposition is treated as ordinary income to the extent of prior deductions for depreciation. For real property, recapture amount is the excess of accelerated depreciation over straight-line depreciation. Section 1250, 1245, 168(b)(3)

6. An investment tax credit gives a taxpayer a one time credit upon purchase of a qualifying asset. While a deduction simply reduces taxable income, a credit produces a dollar for dollar reduction in taxes owed.

7. Useful life of tangible assets is no longer determined on an individualized basis; instead, each tangible asset falls within a specific category of assets and must be depreciated over the recovery period applicable to that category. The motive for generous cost of recovery rules was the desire to stimulate investment.

8. Tangible assets are depreciable under section 168. Cost recovery begins when property is placed in service. There are six different classes of personal property – six different recovery periods. The method for real property is straight-line

9. When client asks how/if to take a deductions:a. Start is 167(a) – ask if property is used in trade/business or held for production of

income. Can’t just look at asset, have to know how it’s used/held b. 168 – didn’t change the scope of depreciation, changed way it’s calculatedc. 168(b)(1) – applicable depreciation method is the 200% declining balance method

(unless (b)(2) or (b)(3) apply)i. Gives more depreciation in earlier years and less in later yearsii. Total amount of depreciation you can take on a $100,000 asset is $1000,000.

200% declining balance - $40,000 deduction in first year (200% of straight line year 1 deduction of $20,000). Adjusted basis at the end of year 1 would be $60,000. You can depreciate the entire amount that you paid for the asset.

iii. You can elect to take straight line depreciation if you wish (b)(3)(D), or it may be required under (b)(3) (why would you want this? Steady income stream, may want to time deductions for where you have income, etc)

d. Section 168 is example of national behavior modfication – encouraging people to buy assets by giving accelerated depreicaiton and allowing depreciation of entire cost

e. 168(c) recovery period is period over which we depreciate the asset – useful life. Behavior modification – IRS is directed to put assets w/a useful life of 8 years into 5 year classification – basically gives triple accelerated depreciation (numerically, chronologically and by amount of salvage value because there is none).

10.Recapture rule transforms capital gain, which can be offset by capital losses, into ordinary gain, which can’t be offset by capital losses (except for $3,000/year for individuals). Recapture gain not eligible for installment method; 453(i). amount of recapture gain reduces amount of deduction for gift of property to a charity; 170(e).

11.Goodwill and other intangibles – intangible assets are subject to 167 and aren’t eligible for accelerated statutory methods of depreciation. An individual who acquires more than one asset in a single transaction must allocate a portion of purchase price to each asset – how do we determine value of goodwill, reputation, customers, etc? 197 – provides a 15 year amoritization of long list of intangibles.

H. “Legitimate” Tax Reduction, Tax Avoidance, and Tax Shelters1. Tax Shelter Problem – term is used to describe investment unrelated to a taxpayer’s trade or

business or taxpayer’s normal investments that is certain to produce tax loss but isn’t expected to produce economic loss. Most tax shelters generate paper losses used to offset income from other sources. Tax shelters attempt to achieve some combination of:

a. Deferralb. Conversion, andc. Tax arbitrage

2. Real estate tax shelter – break even investment produces a tax loss because of depreciation. Financial and other tax shelters – deferred annuity. IRS decision – an obligation, the payment of which is so speculative as to create only contingent liability, cannot be included in the basis of the property.

3. Estate of Franklin v. Commissioner – would work only if parties could prove the contract price was equal to FMV. Purchase price exceeds a reasonable estimate of FMV. Depreciation is not predicated upon ownership of property but rather upon investment in the property. Only Romeny’s had an investment in the property. To justify deduction, debt must exist; potential existence will not do.

4. 168(b)(3) – straight line method is to be used for all real estate property. 168(c) – applicable recovery period for residential rental property is 27.5 years; for nonresidential real property is 39 years – real estate gets a bad deal – must elect straight line depreciation and it’s spread over a lot of years. Why? Most tax shelter problems were in real estate

5. Congressional Response to Tax Shelters – Congress responded with a number of statutory provisions designed to defeat or discourage tax sheltering activity: TERFA - 1982

D. Review of Chapter 4 through 6Prepare answers to Review Problem 2; bring questions

Chapter 8 – Capital Gains and LossA. Introduction, mechanics, policy (695-705, 356-67)

A distinction has been drawn between ordinary income (salaries, interest, dividends, and profits from running a business) and capital gain (gain from the sale or exchange of property such as real estate, stocks, and bonds).

Short term gain – gain from the disposition of assets held from one year of less Long term gain – gain from the disposition of assets held for more than one year – 1222(3)

o Doesn’t fit in any exception in 1221(a) – is an investment asset (capital asset)

o Gets a special tax rate – roughly half of what it would be if it was something other than long term capital gain

Maximum nominal rate for individuals on most common types of long term capital gain is 15%. Rules are complex and section 1(h) doesn’t make things any easier

Additional advantage, apart from favorable tax rates, to characterization of income as capital gain: if transaction’s characterized as involving sale of property, not only is the gain capital in nature, but before gain is calculated a deduction is allowed for the basis of the property. Capital losses are not all that advantageous.

Example – A trades car for B’s boat. A’s car – fmv: 25,000; AB: 17,000. B’s boat – fmv: 25,000; AB 12,000. Gain = AR-AB. A has $8000 gain. B has $13000 gain. Administrability issue – ability to pay problem. Say B owned boat for 5 years, $13,000 should be divided by 5 in order to find appreciation during each year – 2,600/year. Bunching – what these sections are designed to eliminate – bunching results in over taxing.

Hess looks at 1221 as an ordering section (orders things into 3 categories):o Inventory/property SOLD in a trade or business – 1221(a)(1)o Property USED in a trade/business – 1221(a)(2). Kicked out of 1221 and into 1231.

Common examples – heavy equipment and buildingso Investment assets – taxpayers didn’t use in trade or business, gain achieved over a

number of years (classic bunching problem). Investment assets are only defined in the negative in section 1221(a) – default rule is investment – 1221 by implication. Capital asset is anything NOT listed in 1221(a)

Don’t define an asset by what it is; define an asset by what taxpayer does with it.B. Property held primarily for sale to customers (706-19, Chirelstein 368-69, 405-08)The Statutory Framework

1. Capital gain/loss arises from the “sale or exchange of a capital asset.” Section 1222. Capital asset defined as “all property” with various exceptions listed. Property is a broad and vague term; courts have interpreted it narrowly. There’s a limitation in 1222(2) (depreciable property and real property) that virtually swallows it up – 1231.

Policy1. Major arguments have been used to justify favorable treatment of capital gain:

Bunching – the effect of taxing the entire gain in one year may be subject to all, or almost all, of the maximum rate even though it might well have been taxed at a lower rate if realized ratably during the entire period of ownership of the asset

Lock in – a tax on capital gain tends to induce people to hold assets when they might otherwise sell and reinvest the proceeds in some other way. Section 1014. The lock in effect leads to immobility of capital and inefficient uses of capital, with assets not being held by those who will put them to best use.

Inflation – favorable treatment of capital gain mitigates possible unfairness of taxing gains that are attributable to inflation and are not therefore not “real” gains

General incentive – favorable rates of taxation of capital gains reduce the aggregate tax burden on returns on investment and thus provide an incentive, or reduce the disincentive, to saving, investment, and economic growth

Incentive to new industries – since new industries tend to generate capital gain, favorable treatment of capital gain will tend to stimulate such industries.

Unrealized gains are not taxed – the favorable rate of taxation of capital gain reduces the disparity in treatment of realized and unrealized gains

Double tax on corporate earnings – corporate income is in some sense taxed twice; once when earned by the corporation, and once when repatriated to the shareholders in the form of dividends or corporate repurchase of shares

2. Rationale for the limitation on Deduction of Capital Losses – capital losses are subject to unfavorable set of tax rules. Individuals may deduct capital losses from capital gain, but individuals

with capital losses in excess of capital gain may deduct only $3K of such losses in any year. Corporations may deduct capital losses from capital gain. 3 explanations for limitation on deductibility:

1) necessary to prevent taxpayers from manipulating the recognition of gains and losses to recognize “false” losses

2) without the limitation, the taxpayer would have a strong incentive to sell the loss assets and retain the gain assets

3) unrestricted allowance for deductions of capital losses would decrease tax revenue; Congress is more concerned about revenue than fairness/economic rationalityThe Mechanics of Capital Gain HandoutProblem 1 – is it capital or ordinary? Is it long term or short term? Netting – subtracting (which every number is bigger, subtract the smaller number from it)Net Long Term Capital Gain = 10,000(LTCG) – 4,000(LTCG) = 6,000 – section 1(h) tax rateNet Short Term Capital Gain = 5,000 (STCG) – 2,000(STCL) = 3,000

Short term gain is taxed as if it were ordinary income at the 35% rate Goes into gross income – taxed at 35% Long term transactions get the benefit, short term transactions are treated like ordinary

incomeProblem 2Net long term capital loss = 14,000 (LTCL) – 10,000 (LTCG) = 4,000Net short term capital gain stays the same = 3,0004,000-3,000 = 1,000 net capital loss (L). section 1222 says to keep netting until you have one number(all deductible under 1211(b) because it is ordinary income less than 3,000 – cap on deductible ordinary income)Problems 3 & 412,000 (stcl) – 5,000(stcg) = 7,000 net short term capital lossNet long term capital loss remains the same at 4,000. Total net loss = 11,000Sheltering income – you have sheltered 10,000 of long term capital gain with your loss1211(b) – can’t deduct more than 3,000 of losses from ordinary income. She can take 3,000 deduction of ordinary income this year – does not eat up long term or short terms1212 requires taxpayers to use up short term loss first. Reason 1211(b) deduction is a deduction against ordinary income. A deduction against either ordinary income or short term capital loss yields a potential benefit at the highest tax bracket, which is 35%. A deduction against most long term capital gain, on the other hand, cannot yield greater benefit than 15% because normal long term capital gains are never taxed at a higher rate than 15% under 1(h)For the next year – LTCG – 10,000; LTCL – 4,000 (carry over)

STCG – 5,000; STCL – 10,000 plus 4,000 (carry over)6000 LTG; 9000 STL = 3000 net capital loss – all can be deductible under 1211(b)You only do second netting step if 1 is a loss and 1 is a gain. If they are both the same, add them together).

Bielfeldt v. Comm’r – B seeks to overturn a decision by Tax Court denying him the right to offset trading losses he incurred against all but $3,000 a year in ordinary income. (B trades stock in his own home. Sounds like someone who is engaged in passive investment. He would not want to be engaged in passive investments because he wants to deduct more than 3,000/year – losses on assets that ordinarily would be capital assets. He wants them to be inventory so that they can be ordinary losses?). The standard distinction between dealer and trader:* dealer – income is based on services he provides in the chain of distribution of goods he buys and resells. Only broker-dealers can have inventory in stocks and bonds (they are not just selling on their own behalf) – generally accepted as the RULE.

* trader – income based on fluctuations in market value of the securities or other assets that he transacts inIRS treats dealer gains and losses as ordinary income. B’s argument would turn a speculator into a dealer for purposes of IRC> B was a speculator – his activities are in most cases outright speculation of interest rate movements. Affirmed.

Inventory – section 1221(a)(1) – property SOLD (or held primarily for sale) to customers in the ordinary course of trade/business; rule: should generate ordinary income and ordinary loss. Purpose of exempting this asset from capital gain is horizontal equity. Characterization of all property is capital (you have to show that it’s NOT capital to get separate treatement).

PROPERTY USED in a trade or business – equipment, etc. – section 1221(a)(2); 1231 – hotchpot (in the middle of inventory and passive investments)

Passive investments – 1221(a) – general rule – these items should generate capital gain and capital loss. A capital expenditure is rarely a capital asset – it is usually a 1231 asset because it’s depreciable property or land.

Malat v. Riddell – Supreme Court defined what primarily meant – principally or of first importance. In mixed motives cases (not inventory because not primarily for sale), the default rule applies – default rule is capital

Assuming taxpayer has only one use for the property, the next obstacle in determining inventory is in a trade or business. Means the same thing in 1221 as in 162 – question of fact (analysis requires several fact determinations). Look at level of busy-ness. AT some point someone is busy enough that what started out as hobby can become business.

You have got to do the netting first. If you have more gains than losses, it is capital. If you have more losses than gains, it is ordinary?

Tax consequence for 1231 asset depends on… o The thrust of 1221(1) – non capital characterization of ordinary business profits. The

broad intent of this section is clear: ordinary business activities generate ordinary income and loss

o Section 475 – requires securities dealers to mark any securities that are not properly treated as inventory or held for investment

2. Primarily for Sale Biedenharn Realty Co. v. United States – Taxpayer bought plantation as an investment. He

began to sell it all. Taxpayer reported 60% as ordinary income and 40% as capital gain (pursuant to agreement with government). IRS claimed it was all ordinary income; taxpayer claimed all capital gain. Winthrop factors:

o Frequency and substantially of saleso Improvementso Solicitation and advertising effortso Brokerage activitieso Additional taxpayer contentions

Court rejects proposition that prior intent is always irrelevant. Congress didn’t intend to automatically disqualify from capital gains bona fide investors forced to abandon prior purposes for reasons beyond their control. Taxpayer’s passivity is in the past; he has since undertaken role of real estate

protaginist. This is 1231 property – property moved from passive investment to property used in a trade or business because taxpayer’s use for it changed. When property becomes residential – it’s inventory – property held for sale to customers in trade/business – 1221(a)(1)

You have to know what the taxpayer is using the property for before you can characterize what type of asset the taxpayer has.

C. Transactions Related to Taxpayer’s Regular Business Activities (720-31; Chirelstein 369-75, 404-05)1. While Congress, in section 1221, broadly defined capital assets as all “property,” the word “property” can’t be given broad, or plain language, definition without violating informed notions of the congressional purpose in providing special treatment for capital gain/loss. The cases that follow reflect efforts of the courts to narrow the concept of capital asset.2. Example of characterization of assets: carpenter buys cherry wood to make furniture. He makes some furniture. He doesn’t have a high demand so instead of making more furniture that won’t sell, he sells the unused cherry wood to another carpenter. The furnished furniture is inventory. The unused cherry wood is not being sold to a customer so not inventory. Closest analogy – corn products. Difference between corn futures and cherry wood – futures are traded on a commodity exchange – makes the futures themselves look like securities. Securities ordinarily go into the investment category. 3. In Corn Products, they sold corn futures (where you lock in a corn price ahead of time; market fluctuation will not affect your price). Are you buying corn when you buy corn futures? No, more of an option contract – the right to buy corn at a fixed price.4. Component Parts of Inventory (raw materials) are NOT ever put in the middle category. They aren’t usually held for more than a year so not depreciable so not 1231 asset. Where do you put them? Inventory because they are substitutes for inventory; will become inventory. Supreme Court in CP: corn futures went under inventory – ordinary income and ordinary loss. “substitutes for ordinary income.”5. Corn Products Refining Co. v. Comm’r – Nothing in the record to show that CP’s futures were separate and apart from its manufacturing operations. Company was trying to protect part of its manufacturing costs. The capital assets provision of section 1221 must not be so broadly applied as to defeat rather than further the intent of Congress (even though the court admits the corn futures do not come within the literal language of the exclusions listed). The definition of capital asset must be narrowly applied. 6. Arkansas Best Corporation v. Comm’r - Capital asset is defined broadly. Bank stock falls within literal definition of 1221. P places all reliance on its reading of Corn Products which we believe is a reading that is too expansive. CP is properly interpreted as involving an application of 1221’s inventory exception. A business connection is irrelevant in determining the applicability of certain of the statutory exceptions, including inventory exception. CP: stands for the narrow proposition that hedging transactions that are an integral part of business’ inventory-purchase system fall within the inventory exclusion of 1221. CP has no application in this case. Holding – taxpayer

D. Fragmentation of Collective Assets; Substitutes for Ordinary Income (783-86, 731-45)1. Williams v. McGowan – Issue: Whether upon the sale of a going business it it to be comminuted into its fragments, and these are to be separately matched against the definition of section 1221, or whether the whole business is to be treated as if it were a single piece of property? Congress plainly did mean to comminute the elements of a business; plainly it did not regard the whole as capital assets. Williams transferred to the Corning Company cash, receivables, fixtures, and a merchandise inventory. (Partnership and sole proprietoryship (an others where the individuals rather than the company are taxed) – treated as box of assets and selling an undivided fractional interest in every asset).