Federal Income Tax OutlineFall 2005

Table of ContentsTable of Contents..........................................................................................................................................................1Abbreviations in This Outline......................................................................................................................................3I. Overview of Income Tax System..............................................................................................................................4

A. Sources of Tax Law..............................................................................................................................................4B. Tax Litigation.......................................................................................................................................................4C. Steps in Computing Taxable Income.................................................................................................................5

II. Ethics.........................................................................................................................................................................5A. Standards for Tax Attorneys..............................................................................................................................5

1. ABA Formal Opinion 85-352...........................................................................................................................52. IRS Circular 230 – Best Practices and Other Standards (31 C.F.R. § 10.34).............................................53. Section 6694.......................................................................................................................................................6

B. Standards for Taxpayers.....................................................................................................................................6III. The Scope of Gross Income...................................................................................................................................6

A. Cash Receipts: Does Source Matter?.................................................................................................................61. Generally, No.....................................................................................................................................................62. Tax-Free Recovery of Capital is Allowed.......................................................................................................73. Statutory Exclusions (Congress Says Source Matters)..................................................................................7

B. Is it taxable if it isn’t cash?..................................................................................................................................91. Generally, Yes, as far as § 61 is concerned.....................................................................................................92. Two Great Non-Statutory Exclusions of Non-Cash Economic Benefits....................................................103. Statutory Exclusions Based on the Non-Cash Nature of the Benefit.........................................................104. De Facto Administrative Exclusion – Frequent Flier Miles: CB 213-221.................................................14

C. Income Inclusions as Mistake-Correcting Devices.........................................................................................141. The Annual Tax Accounting Period..............................................................................................................142. Loans and Cancellation of Indebtedness......................................................................................................143. The Tax Benefit Rule......................................................................................................................................17

IV. Property Transactions..........................................................................................................................................17A. The Realization Doctrine...................................................................................................................................17

1. Eisner v. Macomber........................................................................................................................................182. Unrealized Appreciation, Stock Dividends vs. Cash Dividends.................................................................183. The Constitutional Issue.................................................................................................................................18

B. Manipulation of the Realization Rules.............................................................................................................181. The Substance of a Sale without Realization of Gain..................................................................................192. The Substance of Continued Ownership with Realization of Loss............................................................193. “Cherry Picking” – § 1211 Capital Loss Limitations..................................................................................19

C. Nonrecognition: CB 269....................................................................................................................................191. The concept of nonrecognition.......................................................................................................................192. Like-Kind Exchanges: CB 272; HB 220........................................................................................................193. Involuntary Conversions (§ 1033): CB 277; HB 237...................................................................................204. Permanent Exclusion of Gain on the Sale of a Principal Residence..........................................................20

D. Installment Sales................................................................................................................................................21E. Annuities.............................................................................................................................................................21F. Basis Rules for Property Transferred by Gift or Bequest..............................................................................22

1. Property Transferred by Inter Vivos Gift....................................................................................................222. Property Transferred at Death......................................................................................................................223. Part Gift, Part Sale Transactions..................................................................................................................22

G. Basis Allocation: Piecemeal Asset Dispositions and Other Contexts: CB 294..............................................22IV. Personal Deductions.............................................................................................................................................23

A. Charitable Contributions (§ 170): CB 356; HB 519........................................................................................231. The Rationale..................................................................................................................................................232. The Amount of the Deduction........................................................................................................................233. Eligible Recipients...........................................................................................................................................24

1

4. Limitations on Deductions and Carryovers.................................................................................................245. Vehicle Donations............................................................................................................................................246. Quid Pro Quo..................................................................................................................................................24

B. Interest Expense: CB 363; HB 490...................................................................................................................251. Qualified Residence Interest..........................................................................................................................252. Business Debt...................................................................................................................................................263. Investment and Passive Activity Interest......................................................................................................264. Educational Loan Interest..............................................................................................................................26

C. State and Local Taxes: CB 375; HB 498..........................................................................................................26D. Casualty Losses: CB 382, 470-478; HB 500.....................................................................................................27E. Medical Expenses: CB 388; HB 514.................................................................................................................27F. Miscellaneous Itemized Deductions: CB 394; HB 527....................................................................................28G. Reduction of Itemized Deductions for High Income Taxpayers: CB 395....................................................28

V. Business Expense Deductions................................................................................................................................28A. What is an “Ordinary and Necessary” expense? – CB 495............................................................................28

1. Necessary.........................................................................................................................................................282. Ordinary..........................................................................................................................................................28

B. What is a “Trade or Business”?........................................................................................................................29C. Public Policy Limitations...................................................................................................................................29D. Lobbying Expenses............................................................................................................................................29E. Reasonable Compensation.................................................................................................................................29F. Travel and Entertainment.................................................................................................................................30

1. Travel...............................................................................................................................................................302. Entertainment.................................................................................................................................................30

G. Patrolling the Business-Personal Borders.......................................................................................................311. Hobby Losses...................................................................................................................................................312. Vacation Homes..............................................................................................................................................323. Home Office.....................................................................................................................................................324. Education Expenses........................................................................................................................................325. Work-Related Clothing..................................................................................................................................33

VI. Capitalization and Cost Recovery.......................................................................................................................33A. Capitalization and Depreciation: The Basics..................................................................................................33B. What is Depreciable?.........................................................................................................................................33C. What Costs Must Be Capitalized?....................................................................................................................34

1. Self-Produced Property..................................................................................................................................342. INDOPCO........................................................................................................................................................343. Repairs.............................................................................................................................................................344. Expenses to Create or Maintain a Business Reputation..............................................................................345. Job Hunting Expenses....................................................................................................................................35

VII. Tax Accounting...................................................................................................................................................35A. Generally.............................................................................................................................................................35B. Cash Method: Constructive Receipt.................................................................................................................35C. Accrual Method..................................................................................................................................................35

1. All Events Test, Clear Reflection of Income, and Economic Performance...............................................352. Early Cash Receipts of Accrual Method Taxpayers....................................................................................36

VIII. Tax Preferences.................................................................................................................................................36A. Tax Shelters........................................................................................................................................................36

1. Passive Loss Rules of § 469............................................................................................................................362. Judicial Anti-Abuse Doctrines.......................................................................................................................36

B. Alternative Minimum Tax.................................................................................................................................37IX. Taxation and the Family......................................................................................................................................37

A. Tax Allowances for Family Responsibilities....................................................................................................371. Allowances for Child Care Expenses............................................................................................................372. Child Tax Benefits Not Based on Expenditures...........................................................................................38

B. Income Tax Treatment of Marriage.................................................................................................................38C. Income Tax Consequences of Divorce..............................................................................................................38

2

D. Earned Income Tax Credit................................................................................................................................39X. Identifying the Proper Taxpayer (Attribution)...................................................................................................39

A. Earned Income...................................................................................................................................................39B. Income from Property.......................................................................................................................................39

XI. Capital Gains and Losses.....................................................................................................................................40A. Mechanics of Net Capital Gain Computation.................................................................................................40

1. Long and Short Term Capital Gains and Losses.........................................................................................402. Netting of Long and Short Gains and Losses...............................................................................................403. The Several Capital Gains Rates...................................................................................................................404. Netting the Special Rate Categories..............................................................................................................41

B. Limitations on Deductions of Capital Losses...................................................................................................411. Rationale..........................................................................................................................................................412. The Capital Loss Limitation Rule.................................................................................................................413. A Big Exception for Small Business Stock....................................................................................................414. Capital Loss Carryback and Carryover.......................................................................................................41

C. Definition of a Capital Asset.............................................................................................................................411. Property Held for Sale to Customers............................................................................................................412. Property Used in a Trade or Business...........................................................................................................42

D. Sale or Exchange Requirement.........................................................................................................................42E. Substitutes for Future Ordinary Income.........................................................................................................42

Abbreviations in This OutlineCB – CasebookHB – HornbookP – Publication 17

3

I. Overview of Income Tax SystemUnit 1: CB pp 1-2, 27-32 (skip chart on 28-29) and Introduction (HB pp 1-8)

A. Sources of Tax Law The Internal Revenue Code – subject to any constraints imposed by the U.S. Constitution. Regulations promulgated by the Treasury Department. In some cases, Congress has delegated to the

Treasury the authority to establish substantive rules (“legislative regulations”) rather than merely to interpret the Code (“interpretive regulations”). If a court believes that a Code provision could reasonably be interpreted in more than one way, the court will uphold any reasonable regulatory interpretation. Chevron U.S.A. v. Natural Resources Defense Council, 467 U.S. 837 (1984).

Revenue rulings and revenue procedures published by the IRS.o A revenue ruling sets forth the IRS’ view as to how the Code applies to a hypothetical set of facts.

A ruling does not have a presumption of validity. However, a taxpayer may rely on factually applicable taxpayer-favorable ruling (unless and until the IRS revokes the ruling).

o Revenue procedures have the same legal status as revenue rulings, but they resemble regulations in format

Letter ruling. For a fee, a taxpayer may request a private letter ruling from the IRS. The taxpayer submits to the IRS a description of the proposed transaction and the taxpayer’s argument as to why favorable tax treatment is warranted under the applicable law. If the IRS issues a favorable ruling, the taxpayer to whom the ruling is issued may rely on it, even if the IRS later decides the legal analysis is wrong. The difference between a revenue ruling and a letter ruling is that a taxpayer’s reliance on a letter ruling issued to another taxpayer is not protected.

The Treasury and the IRS rely on detailed reports from the House and Ways and Means Committee and the Senate Finance Committee in interpreting the Code.

Bluebook – After the enactment of major tax legislation, the Staff of the Joint Committee on Taxation usually publishes a “General Explanation” (or “Bluebook”) describing the legislation. Bluebooks are largely compiled from the House and Senate committee reports. Since they are written after the legislation has been enacted, Bluebooks are not really legislative history and they do not have the authority of pre-enactment committee reports.

Judicial Opinions

B. Tax LitigationThere are three judicial forums in which a taxpayer can litigate:1) U.S. District Court for the district in which the taxpayer resides2) Court of Federal Claims (no juries)3) U.S. Tax Court

In the District Court and the Court of Federal claims, the tax payer can only litigate after paying the disputed tax and suing for a refund. In Tax Court, the taxpayer can litigate without having first paid the tax. A taxpayer invokes the jurisdiction of the Tax Court by filing a petition within 90 days of the date of a notice of deficiency issued by the IRS.

Tax Court is headquartered in Washington, D.C. Tax Court judges ride circuit throughout the country, so a taxpayer does not have to travel to Washington to present her case. Most tax opinions are issued by a single judge but important issues can be submitted to a panel of all judges, sitting en banc. All Tax Court trials are bench trials (no juries). Opinions are designated as either “memorandum” or “regular” opinions. A memorandum opinion applies well-established law to the facts of a particular case, while a regular opinion involves more interesting legal issues. Both types of opinions have precedential value, although regular opinions have somewhat greater weight, and en banc opinions (identified as “reviewed by the Court”) have particularly strong precedential value.

The appeal from either the Tax Court or a district court is to the U.S. Court of Appeals for the circuit in which the taxpayer resides. An appeal from the Court of Federal Claims lies with the Court of Appeals for the Federal Circuit. If a taxpayer loses a case begun in Tax Court, he must pay not only the deficiency, but also interest running from the original due date of the return, at the Federal short-term rate plus three percentage points. If the tax payer wins a

4

refund case, the government will pay the taxpayer both the amount of the overpayment and interest on the overpayment.

C. Steps in Computing Taxable IncomeSee HB 3601.) Gross Income2.) Less: deductions allowed above the line as provided by § 623.) Yields: Adjusted Gross Income (“AGI”)4.) Less: The greater of itemized deductions or the standard deduction5.) Less: Deductions for personal and dependency exemptions6.) Yields: Taxable income7.) Calculate Tax8.) Less: Any tax credits

II. EthicsA. Standards for Tax Attorneys

There are three different rules that a tax attorney must follow when determining whether to advise a taxpayer to take a specific position on his return: (1) an ABA opinion, (2) a Treasury Regulation, and (3) a statutory provision.

1. ABA Formal Opinion 85-352CB 65, HB 649Opinion 85-352 states that a lawyer can advise that a client take a position on his or her return as long as: (1) the lawyer has a good faith belief that the position is warranted in existing law or can be supported by a good faith argument for an extension, modification, or reversal of existing law; and (2) “there is some realistic possibility of success if the matter is litigated.”

The commentary to the opinion states that realistic possibility of success should not be a position having only a 5% or 10% likelihood of success if litigated but rather approximating 1/3. In determining the chance of success, the probability of an audit cannot be taken into account. However, since the commentary is not part of the actual opinion it is unclear how much weight it should be given.

This opinion makes clear the ABA’s position that the attorney has a duty to the client above all else and the filing of a tax return may be the first step in a process that may result in an adversary relationship between the client and the IRS.

Summary: It is okay to take aggressive positions, even ones without substantial authority and it is okay to do so without disclosure, as long as the attorney believes that you have between a 10 and 33 percent chance of success (or greater).

2. IRS Circular 230 – Best Practices and Other Standards (31 C.F.R. § 10.34)CB 69 and HB 652Circular 230 sets out the requirements for attorneys and other agents wishing to practice before the IRS. An attorney who violates these requirements may be fined, suspended, or disbarred from practicing before the IRS.

Circular 230 uses “realistic possibility of success” but defines it as at least a one in three (1/3) chance of succeeding on the merits. An attorney can rely on representations of fact made by his client. He cannot ignore information furnished to him or actually known by him and must make a reasonable inquiry if the information appears to be incorrect or inconsistent with other facts or factual assumptions.

A practitioner may not provide written advice to a taxpayer that: (1) is based on unreasonable factual or legal assumptions; (2) fails to take into account all relevant facts that the practitioner should know; or (3) considers the chance of audit or the chance that the issue will not be raised on audit.

5

If the practitioner knows that third parties will use or rely on this advice in marketing or promoting tax shelters, the IRS will apply a heightened standard of care.

3. Section 6694a. $250 Penalty

This section imposes a $250 penalty on an income tax return preparer who prepares a return (or provides advice in connection with the preparation of a return) that takes an undisclosed position for which there was not a realistic possibility of success on the merits. Adequate disclosure of the position will avoid the penalty as long as the position is not frivolous. Similar to Circular 230, a realistic possibility of success is at least a one-in-three chance of prevailing on the merits.

This penalty is probably most significant for a preparer preparing a high-volume of low-fee tax returns. The preparer may also be concerned that a § 6694 penalty will trigger disciplinary action under Circular 230.

b. $1,000 Penalty § 6694(b)If the understatement was due to willful or reckless conduct, or to an intentional disregard of rules or regulations. The regulations provide that a realistic possibility of success is at least a one in three chance of success on the merits and the chance of an audit (or the chance of getting caught) cannot be considered in making this determination.

B. Standards for Taxpayers§ 6662 imposes a penalty on a taxpayer who files a tax return that understates his correct tax liability by more than the greater of $5,000 or 10 percent of the correct tax liability. The penalty is 20 percent of the understatement. An understatement subject to penalty does not arise from either (1) an undisclosed return position for which the taxpayer had “substantial authority,” or (2) a position that lacks substantial authority, but that is adequately disclosed and for which there is a reasonable basis. Good faith reliance on professional advice is a reason for relief under § 6664(c).

III. The Scope of Gross IncomeA. Cash Receipts: Does Source Matter?

1. Generally, NoIRC § 61 defines gross income as “all income from whatever source derived.” The statute gives 15 examples, but income is not limited to those examples.

Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) – CB p 77Two cases were consolidated in this case. One case involved exemplary damages for fraud and the other involved punitive damages. The issue in this case was whether money received as exemplary damages for fraud or as the punitive portion of antitrust recovery must be reported by a taxpayer under § 61. The Court held that “Congress applied no limitations as to the source.” Not only are the compensatory damages taxable but so are punitive damages. The punitive damages are “accessions to wealth.”

Cesarini v. United States, 296 F. Supp. 3 (N.D. Ohio 1969) – CB p 81The taxpayers bought a piano for $15 in 1957. In 1964, the taxpayers discovered $4,000 in the piano. The taxpayers filed a return claiming the discovered as money. They later filed an amended return excluding the found money and claiming a refund. The taxpayers argued (1) the found money was not income; (2) if it was income, it was income in 1957 and therefore the statute of limitations had run; or (3) if it was income, it should be taxed at the capital gains rate. The court held that it was income in the year it was found and that the concept of income is broad enough to cover this.

Treas. Reg. § 1.61-14 provides that treasure trove is income in the year when it is reduced to undisputed possession.

Baseball: CB 202 – 204; HB 57 - 59What are the tax implications to a fan who catches a ball worth $1,000,000?First, a fan who caught the ball would probably have income of $1,000,000. If he won the lottery or a prize it would be taxed. If the fan catches the ball, if he gives it to someone else (for instance McGwire), the fan is exercising

6

control and it seems the fan would not only be responsible for income tax but for a gift tax. In IRS Press Release IR-98-56, the IRS said there would be no tax implications if fans gave back the ball (but what about not giving it back but giving it to McGwire?). One argument against taxation is that the baseball is like self-created property or imputed income and should not be taxed until it is sold.

2. Tax-Free Recovery of Capital is Allowed§ 61(a)(3) states that gross income includes “gains derived from dealings in property.” § 1001(a) defines the gain on the sale of property as the excess of the amount realized on the sale over the adjusted basis of the property. § 1001(b) defines a taxpayer’s amount realized on a sale as the cash received by the taxpayer plus the fair market value of any non-cash property received. § 1012 defines a taxpayer’s basis in an asset as “the cost of such property.”

3. Statutory Exclusions (Congress Says Source Matters)a. Gifts and Bequests

Commissioner v. Duberstein, 363 U.S. 278 (1960) – CB p 87§ 102 excludes gift from income. The issue was what constitutes a gift. The Court held that a gift is given with “detached and disinterested interest.” The Court “punts” holding that trial courts are better at determining the “mainsprings of human conduct.” The Court stated that the factual findings of lower courts will generally be upheld.

Under § 274(b), businesses can’t deduct a gift as a business expense (only up to $25 per individual). Under § 102(c), any amount given to an employee cannot be excluded from the employee’s income (but see Treas. Reg. § 1.132-6(e)(1) which excludes non-cash low value traditional birthday or holiday gifts as a de minimus fringe).

Hypo: Husband employs wife. H gives W a birthday gift. This is excludable because it is not in the scope of employment.

b. Damages on Account of Personal Physical Injuries (CB 99-103)(i) Generally

§ 104(a)(2) excludes from gross income “any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” The exclusion applies to: (1) non-pecuniary damages for pain and suffering or loss of enjoyment; (2) damages for medical expenses (past and future); or (3) damages for lost wages (past and future).

§ 104(a)(2) is very important for lawyers. Their goal is to get their client within § 104(a)(2). For example, you sue for $6 million. Part of this $6 million is probably threat of punitive damages. You start talking settlement. You use the settlement agreement as a way to classify all the recovery as compensatory rather than punitive.1

Example: When Dennis Rodman kicked the cameraman, the attorney for the cameraman would say that it is excludable because it was for damages. The government argued that not all of that money was for pain and suffering.

(a) Non-pecuniary damagesFor example, if a violinist’s hand is injured and she recovers $1 million, the recovery is not taxed. There are two reasons for this rule. First, the hand is worth $1 million and this is simply a recovery of capital. Second, we don’t kick a person when they are down.

There are two problems with these justifications. First, for other purposes, we assume zero basis of a body part – a person can’t take a deduction if they lose the arm through their own fault. We also have a problem of inequality where one person collects and the other doesn’t.

(b) Medical ExpensesThe policy justification for exclusion of medical expenses is that they would be deductible anyway under IRC § 213. In practice, however, § 104(a)(2) provides better results than § 213 because the medical expense deduction (§ 213) 1 See the hornbook for the example on sexual harassment (I don’t know what page).

7

is only allowed for medical expenses in excess of 7.5 percent of the taxpayer’s adjusted gross income and is not available if the taxpayer takes the standard deduction.

(c) Lost wagesThis exclusion is hard to justify because if the person had not been injured and had earned the wages, the wages would not have been excludable. One argument is the difficulty in separating the lost wages damages from other damages. Another argument is that the exclusion is a tax subsidy for the tort plaintiff’s contingent attorney’s fees.

(ii) The Physical Injury RequirementPrior to 1996, the exclusion applied to damages on account of personal injuries whether physical or not. Courts had great difficulty deciding which nonphysical injuries qualified as personal injuries, damages for which were excludable. In 1996, § 104(a)(2) was amended and the word physical was added. The amendment reduced confusion as to what injuries the section applied, but it is less fair. There is no policy reason why recoveries for physical injuries should be excluded but recoveries for nonphysical injuries should not be excluded.

(iii) Emotional DistressUnder § 104(a), “emotional distress shall not be treated as a physical injury or physical sickness.” However, this does not apply to amounts not over the amount paid for medical care which is attributed to the emotional distress. According to the committee report, it seems that damages for injuries which lead to emotional distress are excludable but damages for emotional distress which leads to injuries is not excludable.

(iv) Loss of Consortium and Wrongful DeathThe committee reports specifically say that loss of consortium and wrongful death are specifically excludable.

(v) Structured SettlementsUnder § 104(a)(2), periodic payments are excludable. If a person receives a lump sum and subsequently invests the lump sum, the lump sum is excludable but gains on the investment are not excludable. However, if a person negotiates a structured settlement, the payor can invest the money and the structured payments are not taxable.

Why wouldn’t people take structured settlement?1) Opportunity cost – you think you can do better2) In real life, companies want to split the tax benefits.

c. Life Insurance§ 101(a) provides that gross income does not include “amounts received […] under a life insurance contract, if such amounts are paid by reason of the death of the insured.”

(i) Types of Life InsuranceThere are essentially two types of life insurance policies: (1) term life insurance; or (2) whole life insurance.

Term Life Insurance: I pay each year an amount which represents the chance of me dying. I am betting that I am going to die; the insurance company is betting that I am going to live. The insurance policy only covers me dying within a specified term. Each year, the insurance policy becomes more expensive.

Whole Life Insurance: This is a combination of term and investment. There is a level payment. Each year, I pay the same amount.

Universal Life: This type has become very popular within the last generation. There are various forms, but they have in common the fact that substantial investment aspects are combined with a core life insurance element. In the early forms of this type, the investment dominated the life insurance aspect. Congress significantly cut back when it added § 7703 to the code. The purpose of which was to make the premiums paid related to the actuarial risk. This limits the ability to create large investment accounts within the umbrella of a life insurance contract.

(ii) Exclusion for Life Insurance Proceeds§ 101 of the Code provides that amounts received as the “proceeds of life insurance” are not includible in gross income.

8

The advantages of exclusion of life insurance death benefits have recently been extended to cover situations in which a dying policyholder receives a pre-death insurance benefit. Many life insurance policies permit payment of all or a part of the death benefit to the insured himself, prior to death, if he is terminally ill. Viatical settlement providers have arisen to purchase or take assignments of an insured’s interest in a life insurance policy if he is terminally ill. Under § 101(g), allows such payments – either from the insurance company or from sale or assignment of rights to a viatical settlement company – to qualify for the exclusion granted by § 101(a) for life insurance proceeds.

Payments made to chronically ill patients may also be excluded as death benefits if the payments are used to defray certain long-term care expenses – a limitation that does not apply to the terminally ill.

d. Other Source-Based Exclusions for Cash ReceiptsOther important exclusions include: (1) § 103 exclusion for interest on municipal bonds; (2) § 121 exclusion for gain on the sale of a personal residence; (3) § 86 exclusion for social security benefits; (4) general welfare exclusion – there is no statutory basis but is has long been recognized by the IRS; (5) § 139 qualified disaster relief payments; (6) there are numerous other exclusion provisions.

B. Is it taxable if it isn’t cash?1. Generally, Yes, as far as § 61 is concerned

Generally, even if it isn’t cash, it is still taxable. The problem is valuation. For example, if you received 100 snickers bars, how would you be taxed? The IRS might try to value you them at 60 cents each since that is what they are sold for. You could attempt to argue that a reasonable person would not buy 100 snickers bars at 60 cents each, rather they should be valued at the bulk price.

Rooney v. Commissioner, 88 T.C. 523 (1987) – CB 110Four of clients of an accounting firm became delinquent in paying for services. The firm allowed their partners to receive goods and services from the clients for free. In return, they reduced the client’s debt to the partnership by an amount equal to the price normally charged for such goods and services by the client to its retail customers. Later, the partners became dissatisfied with the cross-accounting arrangement with the clients. They determined that some of the goods received were overpriced and that some of the services were not satisfactorily performed and that therefore the value to them of the goods and services was less than the normal retail prices charged by such clients. The partners discounted the retail prices of the goods and services received by them from the four clients and reduced the partnership’s gross receipts account by the amount of the discount. The issue before the court was whether the firm could discount the retail prices of goods and services received by considering the partners’ subjective determination of value.

The court held that the fair market value of the goods and services received by the firm was the prices charged by the firm’s clients and not the subjective valuation.

Note that there is still room for argument with objective FMV. For example, one person might use the price charged by K-Mart while the other uses Saks Fifth Ave.

Revenue Ruling 57-374An individual who refuses to accept an all-expense paid vacation trip he won as a prize in a contest does not have to include the FMV of the trip in his income.

The CB points out that the person has constructive receipt and therefore should be taxed. If a check is handed out on December 31, Year 1 but I don’t pick it up until January 2, Year 2, it is still included in taxes for year 1 because I had constructive receipt. The CB also argues that there is no statutory basis for this ruling.

Arguments for allowing this ruling: we don’t tax people for raises they don’t take, and we aren’t taxed for working at the DOJ rather than a law firm. We have the freedom to have less money.

2. Two Great Non-Statutory Exclusions of Non-Cash Economic Benefits

9

a. Imputed Income – p 115If I paint my own house, I am not taxed on the FMV of hiring a professional painter to paint the house. However, if services are paid for in exchange for other services, the FMV of such services must be included in income. See Rooney supra, see also Treas. Reg. § 1.61-2(d)(1). Reasons for not taxing imputed income: privacy and non-erosion of tax base (people won’t do it just to avoid taxes like they would if we excluded bartered income).

The problems with not taxing imputed income are evidenced by the following example (see CB 117-118):Couple 1: H makes $80,000 and W makes $0 because she is a stay out home mom. Couple 2: H makes $40,000 and W makes $40,000. Couple 2 has to pay for day care, house cleaning, and maybe they eat out more, e.g. $16,000.

The problems with imputed income are (1) equality and (2) efficiency. There is a problem with equality there is no horizontal equity. The same income ends in different results. Couple 1 has imputed income of $96,000 which is subsidized by the government. Furthermore, taxation might lead to efficiency problems. For example, see Carla and Chuck (p 118). Assume Carla takes a job for $30,000, pays tax of $12,000, and $20,000 for child services. Society wants her to be a public safety officer because it values that higher than her staying home with her children ($30,000 vs. $20,000) but it isn’t worth it to her.

The IRS has ruled that services means in the context of business. For example, (CB 119) if Karen and Sandra are good friends such that when Karen goes on vacation Sandra feeds Karen’s cats and waters Karen’s lawn and Karen does the same when Sandra goes on vacation, this would not be income because neither is in the business of watching cats and watering lawns.

Helping out a friend only applies to services, it does not apply to property. For example (CB 122 Problem 9) if two professors agree to a temporary house swap, there is income to both professors.

b. Unrealized Appreciation – p 122Unrealized appreciation is not included in gross income. However, upon sale, § 1001, you are taxed on the gain. The usual policy explanation for the exclusion is that taxation of unrealized appreciation would involve tremendous problems of valuation and liquidity. This is not a permanent exclusion but rather a deferral. Taxation is deferred until sale (unless the person dies in which case § 1014 applies).

Anti-flip rule: If I sell securities to realize a loss, I can’t realize the loss if I repurchase the securities within 30 days.

In Eisner v. Macomber, 252 U.S. 189 (1920),2 the Supreme Court held that the exclusion of unrealized appreciation from gross income was required by the Constitution. Although the case hasn’t been formally overruled, later Supreme Court opinions appear to have demoted it from constitutional status. Under the current view, Congress has the power to tax unrealized appreciation to the extent it sees fit. For example, § 475 requires securities deals to “mark to market” their securities each year.

3. Statutory Exclusions Based on the Non-Cash Nature of the BenefitIn general, non-cash economic benefits are includable in gross income in the absence of an explicit exclusion provision.

a. Employer-Provided Health Insurance§ 106(a) excludes from the gross income the value of employer-provided health insurance coverage. § 105(b), excludes from gross income the value of benefits received under employer-provided health insurance, to the extent the benefits constitute reimbursement of medical expenses. If an employee pays through payroll deduction, the amount paid is excluded from gross income. § 125 provides that health insurance coverage may be offered under a “cafeteria plan.” Under the cafeteria plan rules of § 125, a taxpayer who is offered a choice between cash and health insurance coverage, and who chooses insurance, will not be taxed under the doctrine of constructive receipt.

2 See CB 123

10

The regulations state that the exclusion only applies to health insurance for the employee, his spouse, or his dependents as defined in § 152. Treas. Reg. § 1.106-1. If an employer provides health insurance coverage for unmarried partners of its employees, the value of the partner coverage cannot be excluded unless the partner qualifies as a dependent.

Taxpayers who do not have health insurance through their employers, § 213 allows them to claim their medical expenses – including health insurance premiums not excluded under § 106 – as itemized deductions. However, under § 213(a), medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income. This is an example of how the code prefers employer provided benefits to similar items purchased by a taxpayer with his own money.

b. Group-Term Life Insurance§ 79 allows employees to exclude the value of group-term life insurance provided by their employers, for up to $50,000 of insurance. Larger amounts of insurance can be provided, but to the extent that the policy exceeds the $50,000 face amount permitted to be received tax free, § 79 provides that the employee has additional wage income in the amount of the premium properly allocable to the excess coverage.

c. Scholarships and Other Tax Benefits for Higher Education Expenses – CB 1303

§ 117(a) excludes from gross income “any amount received as a qualified scholarship by an individual who is a candidate for a degree” at a college or university. The exclusion applies both to cash scholarships and to scholarships received in-kind (in the form of free or reduced tuition). The exclusion is limited to the amount of the student’s tuition and fees, and the cost of course-related books, supplies, and equipment. § 117(c) provides that the exclusion does not apply to “any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship.” If a grant is in the form of a scholarship but is really compensation for services, it will be treated as income.4

An exclusion is allowed for a qualified tuition reduction, which is defined as a reduction in tuition provided to an employee of an educational institution for the education of the individual or his spouse or dependents (also available for tuition reduction plans at other educational institutions, e.g. through an exchange program). § 117(d)(3). Argument for not taxing: Education is very important and we want to encourage it.Argument for taxing: If you work, make the money, and pay, you are taxed. If you are lucky enough to get a scholarship, you are not taxed. § 117 is thought to operate bizarrely in equity. The Hope Credit and Lifetime Learning credit were intended to make it more equitable. Rev. Proc 76-47 – CB 132-135This revenue procedure gives guidelines for determining whether a grant made by a private foundation under an employer-related grant program to an employee or child of an employee is a scholarship under § 117(a).

In addition to § 117, Congress has enacted the Hope Scholarship Credit (§ 25A(b)) and the Lifetime Learning Credit (§ 25A(c)). The credits are available for qualified tuition (defined in § 25A(f)) and related expenses incurred by the taxpayer, his spouse, or his dependents. The credits are not refundable (no payment if credit is larger than the taxpayer’s liability). Credits mean a dollar for dollar reduction (but sometimes the code puts a percentage limit). The Hope Credit and the Lifetime Learning Credit are phased out based on the taxpayer’s modified adjusted gross income. For married couple filing jointly, the credits phase out from $87,000 to $107,000. For a single filer, the credits phase out from $43,000 to $53,000.

An argument in favor of a government subsidy for education is that it is investment in human capital which we want to encourage. An argument against is that education is a personal consumption choice that the taxpayer made.

3 HB 1184 Under Rev. Rule 77-263, athletic scholarships are not income because when a athlete is offered an athletic scholarship, they receive a scholarship for the entire year, even if they end up not playing any sports.

11

Hope Scholarship Credit – CB 136; HB 644-646; P 247-253The Hope Scholarship credit provides a maximum credit to the person paying the expenses of $1,500 per student for each of the student’s first two years of postsecondary education. The credit allows a 100 percent credit per eligible student for the first $1,000 of tuition expenses (room, board, and books are not covered). Then it allows a 50 percent credit for the second $1,000 of tuition paid.5 The student must be enrolled at least on a half time basis. Since it is available on a per student basis, if there are three qualifying students, the Hope Scholarship Credit may be claimed for all three.

Lifetime Learning CreditThe is a credit of 20% of qualified tuition expenses paid by the taxpayer for any year the Hope Credit is not claimed. The credit is taken by taking 20% of the first $5,000 of tuition paid by the taxpayer in years before 2003 and the first $10,000 after 2003. The credit is calculated per taxpayer and the amount does not change based on the number of students in the taxpayer’s family. The Lifetime Learning Credit can be claimed for an unlimited number of years and can be used for both undergraduate and graduate tuition and fees.

§ 222 Deduction for Qualified Tuition§ 222 allows you to deduct rather than claiming a credit – whether this is better than hope or lifetime depends on your marginal rates. Taxpayers can deduct, above the line, a portion of their “qualified tuition” (which means they can take this in addition to the standard deduction). For years before 2006, taxpayers with AGI that does not exceed $65,000 ($130,000 for joint returns) may deduct up to $2,000. Qualified tuition is the same definition as for the Hope Credit and the Lifetime Learning Credit. You cannot claim both the deduction and the Hope or Lifetime Credit. 

d. Fringe Benefits (§ 132): CB 205-208; HB 59-65An employer may provide fringe benefits to an employee as compensation for working for the employer. Under the broad definition of § 61, the presumption is that such benefits are income. § 132 provides an exclusion from gross income certain fringe benefits. As to (1) and (2) below, they are only available to highly compensated employees only if offered to other employees on a nondiscriminatory basis (nondiscriminatory means compensation in this context). § 132(h)(1) provides that retired and disabled employees and surviving spouses are treated as employees for purposes of subsections (a)(1) and (2). In addition, spouses and dependent children are treated as employees under § 132(h)(2). Parents of an airline employee are treated as an employee and can get free standby tickets under § 132(h)(3).

(1) A no-additional-cost service: § 132(b)This is a service provided by an employer to an employee if: 1) the service is offered for sale to customers in the ordinary course of the employer’s line of business in which the employee is performing services; and 2) the employer incurs no substantial cost (including foregone revenue) in providing the service to the employee (determined without considering any amount paid by the employee for the service). Also, employers can have reciprocal agreements where the employers provide services to each other’s employees if the reciprocal agreement is in a written agreement and no employer incurs any substantial additional cost. See § 132(i).

(2) A qualified employee discount: § 132(c)With respect to a product, the discount cannot exceed the difference between the sales price of the product and the cost to the employer. With respect to a service, the discount cannot exceed 20% of the price at which the services are offered by the employer to customers. If the discount is greater than these limits, only the amount of the discount which does not exceed these limits is excludible and the balance is includible in the income of the employee. The property cannot be real property or property held for investment. In addition, the discount must be on property or services offered in the ordinary course of the line of business of the employer in which the employee is performing services.

(3) A working condition fringe: § 132(d)

5 The 50% requires the taxpayer to have some responsibility but as the hornbook points out, there is no incentive for the taxpayer not to incur the first $1,000 and for the second $1,000, 50% is pretty generous.

12

This is any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction to the employee under § 162 (ordinary and necessary business expense) or § 167 (depreciation).

(4) A de minimis fringe: § 132(e)This is any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employer’s employees) so small as to make accounting for it unreasonable or administratively impracticable.

An eating facility operated by the employer qualifies if (a) the facility is located near or on the business premises of the employer and (b) the revenue derived from the facility normally equals or exceeds the direct operating costs of the facility. An employee entitled under § 119 to exclude the value of a meal (the meal is furnished for the convenience of the employer and furnished on the business premises) is treated as having paid an amount equal to the operating costs of the facility attributable to the meal.

(5) A qualified transportation fringe: § 132(f)This is qualified parking, transit passes, or transportation in a commuter highway vehicle (vehicle that seats at least 7 people) provided by the employer to the employee. A qualified transportation fringe may not exceed $105 per month for the aggregate of transportation passes and amounts spent on commuter highway vehicles, and $200 per month for qualified parking.

e. Restricted Property and Stock Options: CB 222-230If a taxpayer performs services and property is transferred in connection with performance of those services, then the taxpayer is taxed under § 83(a) on the fair market value of the property at the time of transfer (reduced by any amount paid by the taxpayer for the property). However, transferred property is not taxable if the taxpayer’s rights are not substantially vested. A taxpayer’s rights are not substantially vested if they are subject to a substantial risk of forfeiture and are not transferable. If substantially nonvested property later becomes vested, the tax under § 83(a) is imposed at the time of vesting. The amount included in gross income depends on the value of the property at the time of vesting. The employer’s business expense deduction under § 162 is taken when the employee includes under § 83. The employer is allowed a deduction equal in amount to the employee’s inclusion and in the same year as the employee’s inclusion.

Section 83(c)(1) defines substantial risk of forfeiture and § 83(c)(2) defines transferability. Section 83(a) states that the property is taxable to the person who performed the services if the property is transferred in connection with those services. This means that if taxpayer does work for his employer and the employer gives property to the sister of the taxpayer, the taxpayer is responsible for paying the tax. The same result would be reached through Lucas v. Earl – CB 733.

Under § 83(b), a person can elect to include in gross income in the year in which the property is transferred. However, if this election is made and the property is subsequently forfeited, the taxpayer can’t take a deduction. The taxpayer should always take the § 83(b) election when the election will trigger no current income tax liability because the taxpayer purchased the property for its fair market value. See Alves v. Commissioner – CB 225.

Alves v. Commissioner – p 225The taxpayer, as part of his employment agreement, purchased 40,000 shares of stock at ten cents per share. Both the IRS and the taxpayer stipulated that the shares had a FMV of ten cents per share when the taxpayer purchased the share. In addition both parties agreed that the taxpayer did not make a § 83(b) election. The taxpayer argued that § 83(a) does not apply to purchases for FMV. He argued that “in connection with” meant that the employee is receiving compensation for his performance of services. The court held that the statute applies to all property transferred in connection with the performance of services. It is not limited to compensation. The taxpayer also argued that this is a tax trap of taxpayers who are not well informed. The tax court says too bad “Section 83(b) is but one example of a provision requiring taxpayers to act or suffer less attractive tax consequences.”

13

Section 83(e)(3) states that § 83 does not apply to transfer of an option without readily ascertainable FMV and most options do not have a readily ascertainable FMV. However, when the taxpayer exercises the option she will be taxed under § 83(a). Different rules apply to incentive stock options.6

4. De Facto Administrative Exclusion – Frequent Flier Miles: CB 213-221A Technical Advice Memorandum (“TAM”) is written to an IRS agent in the field instructing the agent how to handle a situation. However a TAM cannot be cited as precedent. A TAM is basically an unpublished ruling. Published rulings may be cited as precedent.

In TAM 9547001 – CB 213, the taxpayer was allowing its employees to keep frequent flier miles earned on trips paid for by the company. The TAM argues that the frequent flier miles are a rebate against the price and therefore allowing the employees to keep the miles is a form of compensation.

In an announcement, 2002-10 I.R.B. 621 – CB 220, the IRS backed down saying that “the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel” did not give rise to tax liability.

Some reasons why this might be the right answer include: valuation problems (but is this any different than other valuation problems we face); administration problems (it might be too expensive to keep track); de minimus fringe (it doesn’t fall under § 132 but it is de minimus fringe in general).

C. Income Inclusions as Mistake-Correcting Devices1. The Annual Tax Accounting Period

The taxable year is arbitrarily Jan. 1 to Dec. 31. In Burnet v. Sanford & Brooks Co.,7 the Court held that the government requires “revenue ascertainable, and payable to [it], at regular intervals.” This causes inequities. For example, if a day trader makes $2 million on December 30 and on Jan. 3, he loses $2 million, although he has no net gain or loss he still owes the government tax on the $2 million.

For businesses (including sole proprietorships) there is some relief through the Net Operating Loss (NOL) provision of § 172, allows a taxpayer with a NOL in one tax year to use the NOL to offset positive income in other years.8 An NOL may be used to offset net income in the two years preceding the loss year and in the 20 years following the loss year. An NOL is carried first to the earliest permissible year, to the extent it exceeds the income in the earliest year, the excess is carried to the following year.

Correction of Income Tax Mistakes:There are two types of mistakes:1) You lacked correct information or advice when you filed the tax return. To correct this, you file an amended return.2) Things turned out differently. Based on the world at the time you filed, you filed correctly. Then the world changed and your taxes become incorrect. For example, on December 31, you receive a check from your law firm for $20,000 and a note which says it is a bonus. You include the $20,000 as income. In January, the firm sends out notice that a mistake was made and the check should have been $2,000. You have an $18,000 loss for the year in which you learned about the mistake. See CB 143 n.4. Even if you discovered the mistake before April 15, you still have to declare $20,000 of income for year 1 and an $18,000 loss for year 2.

2. Loans and Cancellation of Indebtednessa. General Rule

A taxpayer does not have to include money borrowed money in income, but the taxpayer does not get a deduction for repaying the loan. The usual justification is that the taxpayer is no wealthier than he was before the loan, he

6 I am not sure what an incentive stock option is. It is not part of this course and is only included in this outline to be complete.7 See CB 138; HB 6008 Keep in mind that this provision is for businesses only, see § 172(d)

14

received the loan but he also created a liability to repay the loan.9 Similarly, the lender does not have a deduction on making the loan and does not have income on repayment. However, if the loan is discharged, their might be income. § 61(a)(12) assumes that discharge of indebtedness is income. § 108 provides exceptions which remove discharge of indebtedness from income.

In Old Colony Trust v. Commissioner – HB 52, a company paid there president a salary and in addition agreed to pay the president’s income taxes. The Court held the payment of taxes by the company was income to the president, because the president’s wealth was increased by the payment (he didn’t have to pay).

In Clark v. Commissioner – HB 123, tax counsel gave incorrect advice to the taxpayer which resulted in the taxpayer paying $19,000 too much in taxes. The tax counsel reimbursed the taxpayer. The IRS asserted the reimbursement was income. The taxpayer argued that it was merely a return of capital. The court held it was not income.10 The IRS has taken the position that Clark applies when taxpayers pay “more than their minimum proper federal income tax liabilities” and are reimbursed by a third party for those amounts. The IRS has distinguished Clark from other cases where the payment was not due to an error made on the return itself but on an omission to provide advice that would have reduced federal income tax liability. Mistakes on the return are a return of capital but mistakes in planning are not.

In general, Old Colony can be distinguished from Clark because in Old Colony, the company paying the taxpayer’s income taxes was compensatory whereas in Clark, the reimbursement for taxes was a return of capital.

In United States v. Kirby Lumber Co. – CB 141; HB 125Kirby Lumber Co. issued $12 million of bonds, later that year the company purchased back approximately $1 million of these bonds for $862,000.11 Thus, the company saved $138,000. The issue was whether this $138,000 was includable in Kirby’s income. The Court held that Kirby had an accession to income.

In order to have debt cancellation, there has to be a valid debt. Zarin v. Commissioner – CB The taxpayer ran up $3,435,000 in gambling debts at Resorts Hotel. Resorts filed suit against the taxpayer but eventually settled for $500,000. The IRS argued that the $3,435,000 was a loan and the settlement for $500,000 was a cancellation of $2,935,000 of indebtedness. The court held the debt owed to Resorts was unenforceable as a matter of New Jersey law because Resort violated Casino Commission rules. Thus the debt was not one for which the taxpayer was liable and the cancellation was not income. One possible argument is that if it wasn’t a loan, why wasn’t he taxed on the money when he received it? The court seemed to say that it wasn’t real money but rather like monopoly money.

b. Defining Debt Cancellation IncomeBradford v. Commissioner – CB 234H had accumulated about $300,000 in debt. To make his finances look better, W agreed to assume $205,000 by giving a note in her name to the bank in exchange for H’s note to the bank. The bank split the notes into a secured note for $105,000 and an unsecured note for $100,000. Later, the bank, on its books, wrote $50,000 off the unsecured note. The bank offered to sell the $100,000 note for $50,000. H’s half-brother purchased the note for $50,000. The tax court held that the $50,000 writeoff was a discharge of W’s indebtedness. The Court of Appeals reversed. The court held that W never received any income from the transaction. The court compared it to a reduction in price. The person that actually received the discharge of indebtedness was H and he was not before the court.12

9 Note that there are other places in the code where a taxpayer isn’t wealthier yet he is still taxed, for example consider what happens when a taxpayer sells stock. He is no wealthier yet he is still liable for taxes. However, this seems intuitively different because throughout the whole transaction, the taxpayer has made income.10 Their reasoning was that it was not derived from capital, labor, or both, this reasoning was subsequently overruled by Glenshaw Glass, but the result in Clark still applies. It was merely a return of capital.11 Kirby was able to repurchase the bonds for less than their original issue price because interest rates had risen in the economy. Rising interest rates drive bond prices down because richer yields are available throughout the financial markets. An investor could get more money from a higher interest bond so they sell their low interest bonds and buy higher interest bonds.12 Today, the IRS would join both H and W.

15

c. Insolvent or Bankrupt DebtorIf a debtor is insolvent and receives a discharge from indebtedness under the Bankruptcy Code, the amount of income from discharge of indebtedness is excluded from the debtor’s income. See IRC § 108.

d. Debt Relief Associated with the Disposition of Property – CB 154Where the property is purchased for a down payment plus debt obligations of the purchaser, the usual rule is that the basis is the full amount of the purchase price even though some of it is not yet paid. The mortgage plus any other cash or property is included when calculating the amount realized.

In Crane v. Commissioner – HB 178 (discussed in Tufts – CB 157), taxpayer had property with a FMV of $262,000 and a mortgage of $262,000. The taxpayer took depreciation deductions of $25,000. The taxpayer then sold the property for $2,500 cash and assumption of the mortgage. The court held that a nonrecourse mortgage is included in calculating the taxpayer’s basis (e.g. cash paid for the property plus the amount of the mortgage).

Mortgaging property subsequent to its acquisition doe not increase basis. Woodsam Associates, Inc. v. Commissioner – HB 185. The mortgaging of an already-held property is not a realizing event.

For example: Figure – HB 185In year 1, Janice bought Blackacre for $500,000 cash. In year 4, Blackacre is worth $1 million. Janice takes out a nonrecourse mortgage of $750,000. She claims that the $250,000 was income but the statute of limitations has run. In year 10, she allows the bank to foreclose on the property. The court held the mortgage in year 4 was not a realizing event. Therefore, the basis was not increased. On the forclosure, Janice’s basis was $500,000 (the amount she purchased it for) and the amount received was $750,000 (the amount which was cancelled in foreclosure) and therefore she had a gain of $250,000.13

In footnote 37 of Crane, the court declined to consider what would happen if at the time of the sale of the property, the property had a fair market value of less than the amount of the mortgage (this can only happen if the property has declined in value after the mortgage has been put on it). This was answered in Tufts.

Commissioner v. Tufts – CB 157; HB 192The taxpayers obtained a nonrecourse loan in the amount of $1.85 million to build a building. After the building was built, the taxpayers took depreciation which left an adjusted basis of $1.4 million. The FMV of the property dropped to $1.4 million. The taxpayers sold the property to a third party who agreed assumed the mortgage as the full payment. The taxpayers argued that the amount realized was $1.4 million so there was no gain or loss. The IRS argued that the gain was the amount realized was $1.85 million minus the adjusted basis of $1.4 million resulting in a gain of $450,000. The court held the full amount of the nonrecourse mortgage is the amount realized to the taxpayer on the sale of the property even though it is greater than the FMV of the property. It is easy to see this is the correct result. If the result came out the other way, people could take out an excessively high mortgage on a property and depreciate down to the FMV of the property and then sell.

The $450,000 gain in Tufts is often called “phantom gain” or “Tufts gain.”

In O’Connor’s concurrence to Tufts, O’Connor would bifurcate the analysis. The property would be treated as being sold at FMV. Therefore, the gain realized would be the FMV – adjusted basis. The discharge of indebtedness would be the amount of the mortgage – FMV. It only matters which formula you use when the debtor is insolvent.

If the loan is recourse, see Rev. Rul. 90-16 – CB 166.X was insolvent (§ 108(d)(3)) and defaulted on a recourse loan. X negotiated with the bank to transfer the property to the bank and the bank released X from liability. The FMV of the property was 10,000, X’s adjusted basis was 8,000, and the amount due on the debt was 12,000. The ruling held that 2,000 was gain (10,000 FMV – 8,000 adjusted basis) and 2,000 was discharge of indebtedness which would be taxable, except under § 108(a)(1)(B) the full amount of X’s discharge of indebtedness is excluded because that amount does not exceed the amount by which X was insolvent.

13 These are generally the facts of Woodsam Associates – HB 185

16

Therefore, if the debtor is insolvent, O’Connor’s approach is better for the debtor because the amount above the FMV is discharge of indebtedness which is not taxable under § 108(a)(1)(B). O’Connor’s approach is only used for recourse loans. Under Tufts, the amount realized is not the FMV but rather the amount of the loan and there is no discharge of indebtedness.

3. The Tax Benefit RuleThe tax benefit rule applies where a person takes a deduction in one year and it later becomes apparent in a later year the person should not have taken the deduction, if the deduction generated a tax benefit.

In Hillsboro National Bank v. Commissioner – CB 171, the Court held that the purpose of the tax benefit rule is to create transactional parity which corrects a reported transaction which was reported on the basis of assumptions that an event in a subsequent year proves to be erroneous. In the case, the Court gives an example where a taxpayer signs a 30 day lease on December 15.14 On January 10, a fire burns down the building. The tax benefit rule does not apply because the event is not inconsistent with the deduction. This is still a business expense. However, if the taxpayer instead of using it for his business used it to house his family, this would be inconsistent with the business expense deduction and the tax benefit rule would apply.

Another example: Taxpayer lends $1,000 to D in year 1. Later that year, it appears D will never pay the debt, so the taxpayer takes a deduction of $1,000. In year 2, D unexpectedly pays back the $1,000. The taxpayer argues that the $1,000 is not income because it is just repayment of a loan (recovery of capital). This argument would give a phantom deduction (an extra $1,000). Under the tax benefit rule, $1,000 is reported as income for year 2.

In Rosen v. Commissioner – p 176, the taxpayers donated property to a city. They claimed a charitable deduction of $51,250. The next year, the city decided it could not use the property and returned the property to the taxpayers. The taxpayers then donated the property to a hospital taking a charitable deduction of $48,000. The hospital returned the property the next year. The court held that since the taxpayers took a charitable deduction when they transferred the property, the tax benefit rule required them to take the property as income when it was returned to them.

Once you determine that the taxpayers have to include the property as income, the question then becomes how much income?Tax commentators would say $51,250 because the tax benefit rule is a tax correcting device.The IRS conceded and the court held that $48,000 should be included in income because that was the value of the property they were receiving back.If the property increased to $80,000 before it was given back, tax commentators would still say $51,250 while the IRS would say $80,000.

IRC § 111 describes the treatment of deductions and credits if recovery is made in later years.IRC § 1341 is the opposite of the tax benefit rule and applies where a person receives income under a “claim of right” but is later required to repay the money. For an example see p 175 n.6.

IV. Property TransactionsWhen property is sold or otherwise disposed of, there are several steps that must be followed to determine the taxable gain. First, there must be realization, generally a sale or other disposition of the property for consideration. Next, compute the gain or loss realized, which is done by subtracting the amount realized from the adjusted basis of the property. The next step is determining whether the gain or loss will be recognized. If it is recognized, it will have significance for the taxpayer’s tax return. If it is not recognized, the gain or loss will be deferred until some later year. Once it is ascertained that the gain or loss will be recognized, the character of the gain must be determined – whether capital or ordinary.15

A. The Realization Doctrine14 This is a business expense under § 162(a)(3)15 For a graphical view of this process, see HB 150

17

1. Eisner v. MacomberIncome from property must be realized before it can be taxed. The reasons for this include: valuing appreciation (although note that the price of marketable securities is easy to determine and real estate could be appraised) or taxpayer lacks the money to pay for the tax (in the case of marketable securities, the taxpayer could sell off some to pay the tax or if it is real estate tax payer could borrow against the property).

Before the appreciation in value of property can be taxed, there must be a realizing event. The property must be disposed of, usually sold or exchanged for money or other property.

Eisner v. Macomber – CB 251; HB 154Taxpayer owned 2,200 shares of Standard Oil. The taxpayer received 1,100 shares through a stock dividend. For each new share issued, the company transferred $100 (par value) from earned surplus to capital account. The issue was whether the stock dividend was taxable to the taxpayer where the statute specifically says stock dividends. The taxpayer argued that the statute violated the Constitution which required direct taxes to be apportioned according to the population and that it was not income under the Sixteenth Amendment. The court held the stock dividend did not constitute a realizing event, as required by the Constitution. Hence the statute was unconstitutional. To have income, the gain must not accrue to capital, but it must be severed from the capital for the taxpayer’s separate use.

Holmes dissented, saying that income included the stock dividend; therefore, the stock dividend should be taxed. Brandeis argued that if the company had made a cash dividend at the same time it offered stock and the taxpayer used the dividend to buy the stock, the taxpayer would have been taxed on the dividend. Therefore, the taxpayer should be taxed on the stock dividend.

2. Unrealized Appreciation, Stock Dividends vs. Cash DividendsOne argument that could have been made is that by distributing a stock dividend, the taxpayer in Macomber was not any wealthier (this was just cutting the same pizza into more slices). However, the same could be said for a cash dividend. In the statute, Congress treated stock dividends the same as cash dividends. To conclude the stock dividends were not taxable, the court found that the statute was unconstitutional (dealt with in the next section). The result of Macomber seems intuitively correct. Problems of valuation and liquidity justify deferring tax of the appreciation of property in the first place, these problems don’t disappear when the owning of stock creates a stock dividend. The shares received in the stock dividend have the same problems with valuation and liquidity. A cash dividend does not have these problems and can easily be taxed.

3. The Constitutional IssueThat statute in question in Macomber clearly required taxation of stock dividends. The court uses the following reasoning to find the statute unconstitutional:1) Unless the Sixteenth Amendment applies, a tax on stock dividends is an unconstitutional unapportioned direct tax on personal property.2) The Sixteenth Amendment allows an unapportioned tax on “income.”3) Unrealized appreciation is not “income.”4) Stock dividends are a form of unrealized appreciation.5) Therefore, taxing stock dividends without apportionment is unconstitutional.

The court reasons that unless a gain is clearly separated from the taxpayer’s original invested capital – as it is in the case of a cash dividend – the gain is not income and cannot be taxed by Congress without apportionment.

Later cases have demoted Macomber from Constitutional status to administrative simplification (valuation and liquidity problems in determining tax on stock dividend).

B. Manipulation of the Realization RulesSection 1001(a) states that a taxpayer realizes gain or loss on the “sale or other disposition of property.” This invites two types of taxpayer manipulation: (1) taxpayer wants to dispose of appreciated property through the economic equivalent of a sale without triggering § 1001(a); or (2) a taxpayer owns depreciated property that he wants to retain, technically selling the property while retaining the economic equivalent of ownership.

18

1. The Substance of a Sale without Realization of GainAn example of a technique used by taxpayers to sell without realizing gain was the “short sale against the box.” Congress enacted § 1259, which requires a taxpayer to recognize gain on the constructive sale of any appreciated position in stock.

An example of a short sale against the box:X has 100,000 shares of ABC, Inc., with FMV of $100 million and a basis of $10 million. X borrows 100,000 shares of ABC from Broker. X’s basis in the borrowed shares is $100 million. X sells the borrowed shares for $100 million and pays no tax because X’s basis is $100 million. X then gives the broker the 100,000 shares which have a basis of $10 million (plus a fee for the broker’s work). X has sold her shares in ABC without being taxed.

2. The Substance of Continued Ownership with Realization of LossReg. § 1.1001-1(a) states that an exchange of an asset for another asset is a realization event as long as the exchanged assets differ materially in kind or extent. Congress enacted § 1091 to prevent a taxpayer from selling stock and turning around and buying it again (wash sales). Section 267(a)(1) disallows a loss deduction on a sale or exchange between certain related parties.

3. “Cherry Picking” – § 1211 Capital Loss LimitationsSection 1211 allows an individual to deduct capital losses only against capital gains and $3,000 of non-capital gain. Under § 1212, capital losses can be carried forward to be used against capital gains in later years. This provision prevents taxpayers from “cherry-picking,” selling the stocks which have losses to take a deduction against income while not realizing gains.

C. Nonrecognition: CB 2691. The concept of nonrecognition

There are several situations in which a taxpayer has realized a gain or loss, but the transaction will not be recognized for tax purposes (at least not at that time). The rationale is the taxpayer has maintained a substantially continuous investment, only slightly altered in form. This continuity of investment underlies congressional willingness to defer tax recognition. Nonrecognition transactions include: (1) § 1031 (like kind exchanges); (2) § 1033 (involuntary conversions); and (3) § 121 (sale of a personal residence – unlike the other two, this is not a deferral of taxation but rather a permanent exclusion).

a. ElectivityThese provisions apply to both gain and loss situations; however, taxpayers can usually arrange the transactions so as to avoid applicability of nonrecognition provisions when those provisions would work to their disadvantage. However, sometimes the IRS will assert that the nonrecognition applies to defer a loss.

b. Role of BasisNonrecognition provisions are designed to defer recognition of gain, not to forgive taxation of the gain forever. Therefore, the general idea is to maintain a historical basis in one or more of the new assets.

2. Like-Kind Exchanges: CB 272; HB 220If a taxpayer who holds property used in business or for investment exchanges that property for property of like kind, no gain or loss will be recognized to the taxpayer on the transaction. IRC § 1031. Section 1031 only applies to property used in business or held for investment. This leaves out property held for personal use, such as one’s personal residence or automobile. Section 1031(a)(2) also precludes application to several categories of property including: stocks, bonds, and notes; partnership interests; and inventory property. It can be argued that the policy reason behind this is that there is no sufficient change in investment to recognize gain. Property which is held primarily for sale is not available for § 1031 treatment.16 If property given up and received is held for investment by the taxpayer, the transaction will count as a like-kind exchange for the taxpayer, even if the other party does not hold the property for business or investment.16 HB gives example of case (see HB 221) where the taxpayer put up a sign offering the property for sale before the exchange. Court held the sign disqualified the transaction from § 1031. See Neal T. Baker Enterprises, Inc. v. Commissioner.

19

a. What is an exchange?Section 1031 requires an “exchange” of property; a “sale” will not qualify. If a taxpayer receives both like-kind property and a small amount of money for his property, he will still be regarded as having engaged in an “exchange” of his property. However, if money forms a substantial part of the consideration, then it may not be an exchange and instead a sale.

b. What is Like-Kind?The regulations say that the concept of like-kind refers to the “nature and character” of the property, and not it its “grade or quality.” Some examples are in Treas. Reg. § 1.1031(a)-1(c). The regulations suggest a city property could be traded for a ranch, which suggest that the nature and character of real property which can be exchanged is broad. The regulations suggest that a exchange of real property owned in fee for a lease of real property with 30 years or more to run is an exchange of like kind. Tangible personal property has to be in the same “asset class” to be like-kind. See Treas. Reg. § 1.1031(a)-2.

c. Calculating Basis in the new propertyFirst, it is important to remember that giving boot does not trigger recognition of gain. Receiving boot does. The easy way to calculate basis: the basis of the nonrecognition property received will be equal to the FMV of the nonrecognition property received less any unrecognized gain on the property exchanged (unrecognized gain is equal to unrecognized gain before the transaction minus recognized gain during the transaction).17

d. Three-Cornered ExchangesIn Rev. Ruling 77-297, the IRS approved three-cornered exchanges. B wants to buy A’s property. A wants to preserve gain. A designates property which B purchases and then A and B exchange properties. For A, the transaction qualifies for § 1031. § 1031(a)(3) sets some time limitations for three-cornered exchanges.

3. Involuntary Conversions (§ 1033): CB 277; HB 237Section 1033 provides for the nonrecognition of a cash sale which is followed by a reinvestment within two years, if the cash sale qualifies as an involuntary conversion. Section 1033 requires the two properties to be of “similar or related in service or use.” This standard has been interpreted as more demanding than the “like-kind” standard of § 1031. The policy justifications is generally continuity of investment with the fact that the taxpayer did not voluntarily sell his property. To the extent the taxpayer does not reinvest the proceeds of the involuntary conversion, the taxpayer is taxed.

Hypo: What if X owns land with a basis of $250,000 which is condemned for public use. X receives a condemnation award of $600,000. X buys property with FMV of $560,000. X finances the purchase with $400,000 cash and a mortgage of $160,000. X’s recognized gain is $40,000. The statute says the recognized gain is the amount realized minus the cost of replacement property.

4. Permanent Exclusion of Gain on the Sale of a Principal ResidenceThe general rule is that loss realized from sale or other disposition of the taxpayer’s personal-use property is not allowed. See IRC § 165(c). A loss on the sale of taxpayer’s personal use property, such as a personal residence, jewelry, or a horse, is not allowed. However, gains on the sale of personal-use property are usually taxed.18

Section 121 is the only permanent exclusion of realized gain in the code. Section 121(a) provides that gross income does not include up to $250,000 of gain ($500,000 for married individuals filing a joint return) on the sale or exchange or property, if, during the 5 year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as his principal residence for periods aggregating 2 years or more. The exclusion is not available if the individual has engaged in another sale of a principal residence resulting in exclusion of gain within the preceding two years.

17 This is not how the statute calculates basis, for the way the statute calculates basis, see HB 228.18 This should be discussed elsewhere but other provisions which temporarily disallow losses are § 267 (disallowing losses on transactions between related taxpayers) and § 1091 (disallowing losses from “wash” sales of stocks or securities).

20

For a couple filing a joint return, the couple must meet the following conditions:a) Either spouse meets the requirement of owning the property for two years out of the last five years.b) Both spouses meet the requirement of using the property as their principal residence for two years out of the last five years.c) Neither spouse is ineligible for the exclusion because of having engaged in another sale of a principal residence resulting in exclusion of gain within the last two years.

If the taxpayer does not meet the ownership or residence requirements a pro rat amount of the $250,000 or $500,000 exclusion is allowed if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. To qualify for this pro rata exclusion, according to Temp. Reg. § 1.121-3T, the primary reason for the sale must be employment, health problems, or unforeseen circumstances. Factors relevant for determining taxpayer’s primary reason include: (1) the sale and reasons for the change are proximate in time, (2) the suitability of the property as a principal residence materially changes, (3) the taxpayer’s financial ability to afford the residence materially changes, (4) taxpayer used the property as a residence during his ownership, (5) circumstances giving rise to the sale or exchange were not foreseeable, and (6) circumstances giving rise to the sale or exchange occurred while taxpayer used the property as a principal residence. Examples of unforeseen circumstances include: involuntary conversion of the residence, natural or man made disasters, including acts of war, death of taxpayer or family member, divorce or legal separation, or multiple births.

To calculate the pro rata exclusion: First calculate the number of months the taxpayer lived in the house divided by 24 months (the 2 year requirement). Multiply this ratio by $250,000 ($500,000 in the case of a joint return).

If one spouse meets the requirements but the other doesn’t, the spouse who meets the requirements gets an exclusion of $250,000 which is aggregated with the other spouses pro rata exclusion as calculated above (assuming she meets the requirements of selling for employment, health, or unforeseen circumstances).

This provision is great for someone who moves into a home, remodels it and sells it two years later for a gain within the exclusion amount.

Prior to § 121, there was § 1034 which was not a permanent exclusion but rather a deferral provision which allowed no gain to be recognized on the sale of a principal residence if a new residence was at least equal in cost to the sales price of the old residence. The problems with this was that it encouraged people to buy more expensive houses and locked in wealth.

D. Installment SalesThere are several reasons why a seller might agree to sell property through an installment sale: (1) the buyer is a small business has a lot of goodwill which is hard to value and a loan would be too risky for the bank; (2) the buyer does not have good credit; or (3) the seller doesn’t mind taking the property back if the buyer defaults.

The issue in installment sales is recovery of basis. There are three options for recovery of basis: (1) allow the taxpayer to recover basis up first (this is taxpayer friendly because it defers taxation); (2) allow the taxpayer to recover basis last (very government friendly); (3) pro rata recovery. Section 453 allows a pro rata recovery of basis. Section 453(c) gives the following equation (X is the taxable amount, P is the payments received that year, GR is the gain realized on the sale, and CP is the contract price):

X = P(GR/CP)

Section 453 applies only to principal payments, interest payments are included in the gross income of the seller as ordinary income. If the note does not contain stated interest Original Issue Discount Rules (“OID”) apply. Just know that OID exists.

E. AnnuitiesSimilar to installment sales, Congress has provided a gradual recovery of an annuitant’s basis according to the “exclusion ratio” of § 72(b)(1). This equation is (X is the nontaxable amount; P is the annuity payment; I is the investment in the contract; E is expected return):

X = P(I/E)

21

Section 72(c)(1) says the investment in the contract equals the premiums paid by the taxpayer reduced by any amounts received by the taxpayer before the annuity starting date and excluded from income. Section 72(c)(3) doesn’t define expected return but says that if the expected return depends on the annuitant’s life expectancy, the expected return is to be based on Treasury actuarial tables.

The exclusion is limited to the investment. After the taxpayer recovers her investment, she has to include the entire annuity payment in income. If the taxpayer dies before her investment is recovered, the amount of the unrecovered investment is allowed as a deduction in the taxpayer’s last taxable year. Under § 72(b)(3)(C), this deduction is treated as a NOL (this allows the taxpayer to carry the loss back two years).

F. Basis Rules for Property Transferred by Gift or Bequest1. Property Transferred by Inter Vivos Gift

There are three options for taxing a gift: (1) treat gift as a realization event and tax gain, donee would get property with a basis at FMV; (2) carry-over basis, donee receives donor’s basis and is taxed on the gain when the donee sells; or (3) tax the donor when the donee sells on gain up to point of transfer and tax donee on gain after transfer.

Section 1015 states that the donor’s basis is carried over to the donee. However, if FMV at time of transfer is lower than basis and the donee eventually sells for a loss, then FMV at time of transfer is used as basis.

The following is a “notch transaction”:D gives X stock with a basis of $100 and FMV of $90. X sells the stock for $95. If you apply gain rule (give X the carry-over basis) the basis is $100 and there is a loss of $5. If you apply loss rule (give X the FMV at transfer) the basis is $90 and there is a gain of $5. In this situation, there is no gain or loss. See Treas. Reg. § 1.1015-1(2).

This section does not apply to transfers between spouses; § 1041 applies.

2. Property Transferred at DeathA transfer at death is not treated as a realization event, and § 1014 gives the transferee a basis equal to the property’s value as of the decedent’s death. This provision hurts people who die unexpectedly or with poor advice (basis of property with a loss is stepped down to the FMV).

One argument is that it might be difficult to determine the basis of property since the person who probably knew is now dead.

3. Part Gift, Part Sale TransactionsUnder Treas. Reg. § 1.1001-1(e), if a transfer of property is part sale and part gift, the transferor has a gain to the extent the amount the transferor receives exceeds his basis. For instance if X has property with FMV of $400,000 and basis of $60,000 and X transfers the property to D for $100,000, X has a gain of $40,000 ($100,000 - $60,000). D’s basis would then be determined by Treas. Reg. § 1.1015-4. For a bargain sale to a charitable organization, see § 1011(b).

G. Basis Allocation: Piecemeal Asset Dispositions and Other Contexts: CB 294Gamble v. Commissioner – CB 294The taxpayer bought a pregnant mare for $60,000. The foal the mare carried was believed to be sired by a horse whose yearlings sold for an average of $50,000 each. The taxpayer insured the foal with $20,000 insurance before the foal was born and $30,000 after the coal was born. Taxpayer sold the colt for $125,000. The taxpayer argued that $30,000 of the $60,000 paid for the mare was for the colt and therefore his basis in the colt was $30,000 (the taxpayer argued that this was approximately the stud fee). The IRS argued that the entire $60,000 was for the mare and the taxpayer had no basis in the colt. The court held the basis was $20,000 because that was what the amount the taxpayer insured the colt.

There are several ways the taxpayer could argue that value of the foal (and therefore basis allocation) before birth (at the time of taxpayer’s purchase of the mare): (1) get breeder to estimate value of the foal; (2) cost of breeding

22

(taxpayer lost in this case); or (3) more than the cost of breeding because stud fee only gives a chance of a foal, here a foal existed.

Gamble shows the problem with basis allocation. This allocation problem can also arise when a taxpayer purchases land with a building. The taxpayer (assuming it is for business) can take a deduction for depreciation of the building but cannot take depreciation for the land. How much should be allocated to the building and land?

Treas. Reg. § 1.61-6(a) states that the basis has to be equitably apportioned among the several parts. One way is to use appraisers to appraise the value of the several parts.

IV. Personal DeductionsPersonal deductions usually refer to those deductions that are available only to individual taxpayers. There are above the line deductions which are subtracted from income to reach adjusted gross income (“AGI”). Then there are itemized deductions. Itemized deductions can only be taken if the taxpayer does not take the standard deduction.

A. Charitable Contributions (§ 170): CB 356; HB 5191. The Rationale

One reason for the charitable contribution deduction is to encourage taxpayers to support charitable organizations. This can be justified because the government is relieved of an obligation it would otherwise have had to meet, or on grounds that the charitable organization provides a general public benefit. However, the charitable sector includes organizations which Congress could not be persuaded to support or which Congress would not be permitted to support under the Constitution. Second, taxpayers in the higher brackets have a greater incentive because the tax savings per dollar donated depends on the taxpayer’s marginal tax rate. Finally, it is not clear that allowing deductions for contributions actually results in greater charitable giving.

Another justification is that a charitable deduction is an accurate reflection of income because the taxpayer does not have the consumption of the charitable gift.

Treas. Reg. § 1.170A-1(g) states that “[n]o deduction is allowed under [§] 170 for a contribution of services.” For example, if X is a magician and donates a show to a children’s hospital, X does not get a charitable deduction, but also consider that the show is not included in X’s income because this is imputed income.

2. The Amount of the DeductionThe taxpayer gets a deduction of FMV regardless of the taxpayer’s basis. For example, if X gives charity stock with a basis of $10,000 and a value of $100,000, by logic, the deduction should be $10,000 (because this is what was previously taxed) but X can take a deduction on $100,000 (even though X never paid tax on $90,000). See Treas. Reg. § 1.170A-1(c)(1).

In most cases, the unrealized gain in donated property is deductible only if:19

(1) The gain would have been long-term capital gain had the taxpayer sold the property;(2) In the case of a contribution of tangible personal property, the use of the property by the charity is related to the charity’s tax-exempt purpose; and(3) The property is not given to a “private foundation”Otherwise, the charitable deduction is limited to the taxpayer’s basis in the property.

If the property has a claimed value of more than $5,000, the taxpayer has to obtain an appraisal.

3. Eligible RecipientsSection 170(c) defines the eligible organizations to which deductible contributions can be made. It substantially tracks § 501(c)(3) which is the exemption from federal tax for charitable organizations.

4. Limitations on Deductions and Carryovers

19 See § 170(e)

23

There are limits to the amount a taxpayer can deduct depending on the type of charity, the type of property contributed, and the type of transfer. The limits are a percentage of the taxpayers contribution base which is the taxpayer’s AGI computed without regard to any NOL carryback.

There are two types of charities: (1) charities to whom the taxpayer may contribute up to 50% of his contribution base; and (2) charities to whom the taxpayer may contribute up to 30% of his contribution base.

50% charities include: churches or associations of churches, schools and colleges, hospitals, medical schools or medical research organizations, organizations receiving a substantial part of their support from the state or federal government or the general public, the state or federal government, and certain private foundations. See § 170(b)(1)(A) and Treas. Reg. § 1.170A-9. 30% charities are those organizations qualified to receive deductible charitable contributions but do not qualify as 50% charities. See § 170(b)(1)(B).

If a taxpayer makes contributions to both 50% and 30% charities, the amount of the contributions to the 50% charities are taken first. If those contributions have not exhausted the limit, the contributions to the 30% charities, up to 30% of the contribution base, or the remaining amount on the 50% limit whichever is less, are allowed.

Contributions to 50% charities which exceed 50% of the contribution base may be carried forward for 5 years. Contributions to 30% charities which exceed 30% of the contribution base cannot be carried forward.

If the taxpayer contributes capital gain property, it may be deducted only to the extent it does not exceed 30% of the taxpayer’s charitable contribution base. See § 170(b)(1)(C)(i).

Charitable contributions have to be substantiated according to the regulations. In addition, the taxpayer has the burden of establishing that a charity qualifies for the receipt of deductible contributions.

Corporate taxpayers can deduct up to 10% of their taxable income, computed without regard to their charitable gifts, their dividends-received deduction, and any carrybacks for capital or operating losses. See § 170(b)(2).

5. Vehicle DonationsTo stop abuse of donations of used automobiles, Congress enacted § 170(f)(12). First, taxpayers are only allowed to deduct contributions if the charity provides a contemporaneous written acknowledgement of the donation. The acknowledgment has to give the gross proceeds of the sale of the vehicle and a statement that the deductible amount may not exceed the gross proceeds. This provision does not apply if the charity is going to use the vehicle as part of its charitable mission (e.g. to deliver meals, services, etc.).

6. Quid Pro QuoThe quid pro quo principle is that a deduction is not allowed for a contribution to charity where a person receives some benefit from the contribution.

a. The College Football SagaIn Rev. Rul. 84-132 – CB 406, the IRS declared that a taxpayer who paid money to an athletic scholarship program and was, because of the donation, entitled to buy football tickets for preferred seating, was not a charitable deduction. As a general rule, payment to a charitable organization which results in the receipt of a substantial benefit creates the presumption that no charitable contribution has been made.

In 1986, Congress created a rifle shot provision for LSU and Texas, allowing deductions for their football programs. In 1988, Congress leveled the field by enacting § 170(l) which allows 80% of a gift to be deducted if the gift entitles the taxpayer to purchase seating at athletic events.

b. Intangible Religious BenefitsRev. Rul. 70-47 allowed the charitable deduction of pew rents. Rev. Rul. 78-189 denied charitable contributions by taxpayers to the Church of Scientology for a “fixed donation” made to the church for payment of auditing courses unless the taxpayer can prove that the donation exceeded the FMV of the benefits received. In that case, the taxpayer could deduct the excess of FMV donated.

24

Hernandez v. Commissioner – CB 413The taxpayer argued that the fixed donation to the Church of Scientology was not quid pro quo because the benefit received from the donation was purely religious and payment made to participate in religious service should be automatically deductible under § 170. The Court disagrees holding that there is no exception to the quid pro quo doctrine for religious benefit. Second, the taxpayer argues that denying the deduction violates the Establishment Clause and the Free Exercise Clause of the First Amendment, which the Court denies. Finally, the taxpayer argues that the IRS treats the Church of Scientology different from other religious practices. The Court holds the taxpayer has not established a complete factual record upon which the Court can make a determination. The dissent claimed that it is hard to put a value on these intangible religious benefits.

In Rev. Rul. 93-73, the IRS reversed its position, effectively repudiating Hernandez. The ruling was part of a settlement between the IRS and the Church of Scientology. The IRS does not have the power to overrule the Supreme Court; however, the taxpayer certainly isn’t going to challenge the IRS’ kindness and it is unlikely that anyone else has standing to challenge the IRS.

Sklar v. Commissioner – CB 421The taxpayers argued that 55% of their private school tuition was for religious instruction which was an intangible religious benefit like the auditing in the Church of Scientology. The court held that the IRS policy toward the Church of Scientology facially discriminated among religions which is unconstitutional, but the taxpayers lost because they did not prove that the private school cost more than the public school or that any part of their payment was for intangible religious benefit. The taxpayers lost this case but could refile the case for another tax year and prove the payments.

B. Interest Expense: CB 363; HB 490Section 163(a) states that there is a deduction of all interest paid. However, § 163(h) limits this deduction in the case of personal interest.20 Under § 163(h), all interest is personal unless the taxpayer is a corporation or in the case of a non-corporation, the interest falls under one of the exceptions, which include: business interest, certain amounts of home mortgage interest, investment interest, passive activity interest, and education loan interest. Interest is assigned based on the taxpayer’s use of the borrowed funds on which the interest is paid.

1. Qualified Residence InterestA taxpayer can deduct the interest on mortgages secured by a personal residence. The number of personal residences whose mortgages can generate deductible interest is limited to two, with married couples who file separately being allowed only one residence each. See § 163(h)(4)(A)(ii). Second, the personal residence must secure the mortgage loan whose interest obligation the taxpayer seeks to deduct. Third, the mortgage loan must be either “acquisition indebtedness” or “home equity indebtedness.” Acquisition indebtedness is a mortgage used to buy, build, or substantially improve the residence or refinance existing acquisition indebtedness. IRC § 163(h)(3)(B). Home equity indebtedness is any debt secured by a residence that is not acquisition indebtedness and is limited to the FMV (even if the bank would lend more than the taxpayer’s equity in the home). IRC § 163(h)(3)(C). Finally, the loan amounts generating the deductible interest are limited. Acquisition indebtedness interest is deductible for loan amounts up to $1 million (it is limited to the taxpayer’s basis), and home equity debt interest is deductible up to $100,000.

Pau v. Commissioner – CB 367The taxpayer purchased a home for $1.7 million. They financed the purchase with a mortgage of $1.3 million. They deducted interest from $1.1 million of the mortgage claiming that the aggregate of the acquisition indebtedness and home equity indebtedness resulted in $1.1 million. The court held that all $1.1 million was acquisition indebtedness and acquisition debt was limited to $1 million. Home equity debt could not be used for home acquisition debt. Therefore, the taxpayers were limited to a deduction of interest on $1 million.

2. Business Debt

20 For businesses, §§ 264 and 265 disallow deductions for interest paid on loans used to produce tax exempt income and § 163(d) disallows a deduction for interest on debts incurred to finance investments.

25

Interest is an above the line deduction if it is attributable to the indebtedness incurred in connection with a business (unless it is incurred not by the business but by an employee in which case it is an itemized deduction). § 62(a)(1) and (4).

In Redlark v. Commissioner, the issue was how proximately related a debt must be to the trade or business to justify deductibility. The taxpayer operated an unincorporated business. The business generated income tax liability and interest on the tax liability. The taxpayer deducted the interest arguing that it was “properly allocable” to the business. The IRS argued that the words “properly allocable” are deliberately ambiguous and the Commissioner can determine what is “properly allocated.” The personal income tax is a personal obligation and deficiencies are never properly allocable to a business. The court defers to the IRS’ interpretation and held the interest was not properly allocable.

What is interesting is that the interest was because the business made money and generated income tax liability. If the business had been incorporated before generating income, the interest would have been deductible.

3. Investment and Passive Activity InterestInvestment interest is only deductible against investment gains. No net loss deductions (as in a case where interest expense exceeds income) are allowed.

4. Educational Loan InterestSection 221 allows interest deductions of up to $2,500 on educational loans (at an interest rate of 5%, this would allow interest paid on up to $50,000).21 The loan must be a qualified education loan incurred to pay for qualified education expenses. See § 221(d). For incomes above $50,000 ($100,000 for taxpayers filing jointly), deductibility begins to be phased out. By the time modified AGI reaches $65,000 ($130,000 for taxpayers filing jointly), all deductions on education interest are denied. See § 221(b)(2)(B).

C. State and Local Taxes: CB 375; HB 498A deduction is allowed for state and local taxes. This is justified as a concession to federalism. An argument against this is that citizens of higher taxed states will enjoy greater state and local government services and at the same time lower federal tax liabilities (due to the deduction of state and local taxes). There is an argument that part of state taxes is actually personal consumption because the state provides services to the taxpayer.

Generally, § 164 provides that state and local income taxes, real property taxes, and personal property taxes are deductible. Section 164 also allows deduction of foreign income and real property taxes. Section 164(b)(5) allows a taxpayer to make an election to deduct state sales tax instead of state and local income tax.

One interesting aspect of this is if certain services, such as trash collection, are included in taxes, it is deductible. However, a taxpayer pays for this service separate from taxes, it is not deductible. The reason cities don’t include it in taxes is politically to make the taxes lower.

An issue is determining who is entitled to the deduction. The deduction depends on the legal incidence of the tax, the person who was obligated to pay the tax. Treas. Regs. § 1.164-1(a) provide that taxes are generally deductible only by the person on whom they are imposed. See Loria v. Commissioner – CB 379 (Petitioner’s brother purchased property because petitioner did not have adequate credit. Petitioner paid taxes on the property but the court disallowed the deduction because petitioner was not the legal owner of the property and was not obligated to pay the taxes.)

D. Casualty Losses: CB 382, 470-478; HB 500Losses (casualty) are allowed to individual taxpayers if they are incurred in a trade or business or incurred in a transaction entered into for profit, to the extent not compensated for by insurance. Losses with respect to personal-use property are allowed, subject to certain limitations. See § 165(c)(3). First, the amount of an individual loss to personal-use property is deductible only to the extent that it exceeds a $100 floor amount. The second limit is that the aggregate of all these personal-use casualties, after subtraction of the $100 floor, is only deductible to the extent

21 Note this is $2,500 of interest and is not a limit on the principal like the home mortgages section.

26

it exceeds 10% of the taxpayers AGI. The 10% floor puts pressure on taxpayers to try to show that a casualty loss was business or investment property (which is deductible without regard to the 10% floor).

Steps a Taxpayer must go through to determine the allowable deduction:1) For each piece of property that was damaged, lost, or destroyed, begin with the FMV of the property before the casualty.2) Subtract the value of the property after the casualty (which will be zero if the property is totally lost or destroyed).3) Compare the result with the adjusted basis of the property, taking the lesser of the two numbers as the tentative casualty loss (or casualty gain).4) Subtract the amount of any recoveries from tort-feasors or insurance coverage.5) Once that process is complete for each piece of property lost or damaged in the casualty, the tentative casualty losses are added.6) Casualty gains, if any, and the statutory $100 deductible are subtracted.7) If the taxpayer suffered more than one casualty, the steps above must be repeated for each piece of property in each additional casualty suffered.8) Once the gains and losses from each casualty are computed, the taxpayer adds them together, then subtracts 10% of AGI. This is the amount of the allowable deduction.22

The reason for the business deduction is clear, allowing a deduction is consistent with the general theory of allowing deductions for losses. The reason for a deduction for personal property is most likely because we don’t want to kick a person when they are down. In addition, allowing the deduction allows for a better representation of a person’s true income. An argument against it is that casualty losses are part of the risks of living.

Casualty losses included losses from fire, storm, shipwreck, or other casualty, or from theft. See § 165(c)(3). The IRS has ruled that “other casualty” must be analogous to fires, storms or shipwrecks. In particular, an “other casualty” must be “sudden” (as opposed to gradual or progressive); unexpected (as opposed to anticipated, and unusual (as opposed to commonly occurring). Rev. Rul. 72-592.

In Chamales v. Commissioner – CB 470; HB 503, the taxpayers lived near O.J. Simpson’s house. They claimed their property was devalued due to the crowds that gathered outside his home. The tax court determined this was not a casualty loss, holding that the Ninth Circuit has determined that there is not a casualty loss unless there is actual physical damage or abandonment by physical necessity. The taxpayers here had no such physical damage.

The Eleventh circuit does not require physical damage but instead looks to see if there is a permanent devaluation due to the casualty. It is unlikely that even this standard would have helped the taxpayers.

Rev. Rul. 63-232 – CB 474, held that damage by termites was not a deductible casualty loss under § 165(c)(3) because it occurs slowly over time and not suddenly like fire, storm, or shipwreck.

E. Medical Expenses: CB 388; HB 514The medical expense deduction, § 213, allows a deduction for medical expenses on the taxpayer’s behalf or on the half of the taxpayer’s dependents, but only to the extent the medical expenses exceed 7.5% of the taxpayer’s adjusted gross income. Section 213(d)(1)(A) defines medical care as “amounts paid for the diagnosis, cure, mitigation, or prevention of disease, or for the purpose of affecting any structure or function of the body.”

In Commissioner v. Bilder – CB 389, the taxpayer, a New Jersey resident, took a deduction for rent paid in Florida, because the taxpayer claimed he was advised by his heart specialist to spend the winter in a warm client. The court held the rent was not deductible basing its opinion on a committee report which said that medical expenses does not include any food or lodging while away from home receiving medical treatment. This is arguably a personal consumption. However, the taxpayer could deduct the travel expenses to Florida.

22 If the result is a casualty gain, it is taxable as long-term capital gains if the aggregate of such gains exceeds the aggregate of casualty losses for the tax year. See CB 384, § 165(h)(2)(B).

27

The courts have also denied deduction for private schooling for a taxpayer’s children. See Ochs v. Commissioner – CB 391 n.2; HB 516. The court held that even though boarding school appeared necessary to alleviate demands on the mother suffering from throat cancer, the expenses were not deductible.

Publication 17 contains a list of items which can be included and which cannot be included. See P 154.

The deduction is allowed for expenses “paid” during a taxable year regardless of when the medical services were performed, and regardless of the taxpayer’s usual method of accounting. Thus, it makes sense for taxpayers to bunch their medical expenses if they can. In addition, this may be a situation where married taxpayers may want to file a separate return.

F. Miscellaneous Itemized Deductions: CB 394; HB 527Section 67(a) states that miscellaneous itemized deductions are only allowed to the extent that the aggregate of the deductions exceeds 2% of the taxpayers AGI. Miscellaneous itemized deductions are defined negatively as itemized deductions other than the itemized deductions listed in § 67(b) and the above the line deductions in § 62.

G. Reduction of Itemized Deductions for High Income Taxpayers: CB 395Section 68, provides that itemized deductions must be reduced for taxpayers whose adjusted gross incomes exceed $100,000 ($50,000 in the case of married taxpayers who file separately). This has been indexed for inflation (as of 2003, it was at $139,500). If the taxpayer exceeds that threshold, the total itemized deductions claimed are reduced by the lesser of the two following amounts:1) 3% of AGI minus the threshold2) 80% of the itemized deductions otherwise allowable for the tax year

V. Business Expense DeductionsIn business, income is normally understood to be the net result of a business over a year. Income is calculated by first calculating gross income and then subtracting legitimate expenses of conducting the business. Section 162 allows deductions for “all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Section 212 allows a deduction for “all the ordinary and necessary expenses” for profit-seeking or investment activity.

A. What is an “Ordinary and Necessary” expense? – CB 4951. Necessary

The Supreme Court described the word “necessary” as requiring only that expenses be “appropriate and helpful” in “the development of the [taxpayer’s] business.” Welch v. Helvering. If deductions were allowed only for necessary expenses, the IRS would be reviewing every business expense to make sure the business expense was necessary (do the worker’s really need pens?). The tax jurisprudence rarely denies an expense because it wasn’t “necessary.” See Palo Alto Town & Country Village, Inc. v. Commissioner – CB 495 (taxpayer’s paid a fee to an airplane service to keep a plane available for taxpayer’s on standby basis; the court held it was appropriate and helpful to the business.).

2. OrdinaryWhether an expense is “ordinary” has been more controversial. There are two meanings of ordinary. One meaning is that it is an expense of a normal type. The second meaning, closer to actual usage in most cases, is that “ordinary” means something that is used up in the production of income in the current tax year (as opposed to a capital expense which benefits more than one tax year). In Commissioner v. Heininger – CB 497, the court held that legal expenses were ordinary and necessary, meaning of a type which was expected by a business, because the taxpayer was defending his business and if he lost, he would lose his business.

B. What is a “Trade or Business”?There is no distinction in tax jurisprudence between a trade and a business; they are one and the same. Determining what falls in this category is more difficult. In Higgins v. Commissioner, the Supreme Court held that merely managing a portfolio, no matter how large the portfolio or how expensive the management, was not a trade or

28

business. Congress added § 212 which allows deductions of certain profit-seeking expenses that were not part of a trade or business. However, there continue to be important differences between § 162 and § 212. Generally § 162 expenses are treated more favorably than § 212 (most § 212 expenses are miscellaneous itemized deductions, miscellaneous itemized deductions cannot be deducted from the alternative minimum tax, other deductions depend on whether or not the taxpayer is engaged in a trade or business). However, there are benefits to being under § 212. Income from self-employment which qualifies as a trade or business is subject to self-employment taxes, whereas simply managing an investment does not generate self-income tax liabilities.

In Commissioner v. Groetzinger, the Supreme Court held that the taxpayer was in the trade or business of a gambler. They held that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.” The taxpayer’s gambling was pursued full time, in good faith, and with regularity, for the production of a livelihood. It was not a hobby.

C. Public Policy LimitationsShould deductions be allowed for expenses which violate public policy, for example: payment by a bank robber to a getaway driver or bribes and kickbacks to obtain valuable contracts?

Tank Truck Rentals, Inc. v. Commissioner – CB 509Tank Truck Rental (“Tank”) paid several hundred fines imposed on it for violation of state maximum weight laws. Tank deducted those expenses as ordinary and necessary business expenses. The commissioner denied the deductions. The Supreme Court held that Congress intended to tax net income and not gross income. However, allowing a deduction such as this would encourage violation of state laws by, in effect, subsidizing the fines. Tank argued that the fines were not penalties but rather a revenue toll. The Court disagrees holding that the fines were a penal measure.

In 1969, Congress enacted § 162(f) which denies a deduction for any fine or similar penalty paid to a government for the violation of a law. One problem with this recently, a person commits insider trading, the person settles by donating $200 million to charity. Does the person get a deduction? Arguably, it wasn’t a fine and it wasn’t paid to a government. On the other hand, you could argue this would frustrate public policy.

D. Lobbying ExpensesSection 162(e) prohibits a business expense deduction for lobbying expenses in virtually all cases. In Geary v. Commissioner – CB 516, the taxpayer with ventriloquist dummy attempted to deduct expenses for putting an issue on the ballot to save his puppet. The taxpayer argued it wasn’t attempting to influence the public but rather simply putting the issue before the public. The Court denied the deduction holding that it was a lobbying expense because the broad language of § 162(e)(2)(B) makes non-deductible any amount incurred “in connection with any attempt to influence the general public.”

In effect, Congress is saying lobbying shouldn’t be subsidized by the Federal government.

E. Reasonable CompensationSection 162(a)(1) allows “a reasonable allowance for salaries or other compensation for personal services actually rendered.” If the officers and executives of a corporation are substantially identical with its major shareholders, a temptation may arise to distribute some of the earnings of the corporation as compensation for services rather than through dividends to avoid double taxation.

In Exacto Spring Corp. v. Commissioner – CB 521; HB 367, the tax court applied a seven factor test to determine reasonable compensation: (1) the type and extent of the services rendered; (2) the scarcity of qualified employees; (3) the qualifications and earning capacity of the employee; (4) the contributions of the employee to the business venture; (5) the net earnings of the employer; (6) the prevailing compensation paid to employees with comparable jobs; and (7) the peculiar characteristics of the employer’s business. In applying the factors, the tax court held the president of Exacto Spring was over-compensated. The Court of Appeals reversed rejecting the test used by the tax court and instead applied the independent investor test. Under this test, the court looks to see whether the investors

29

are receiving an acceptable level of return on their investment. If they are, the court believes that the compensation is presumptively valid.

Other courts applying the independent investor test refer to the test as a “lens” through which one applies the seven factor test.

F. Travel and Entertainment1. Travel

Section 162(a)(2) allows a deduction for traveling expenses, including meals and lodging, while away from home in pursuit of a trade or business. The IRS has added two other requirements: the taxpayer must be away from his “tax home” in order to qualify for these deductions and the taxpayer must satisfy the “overnight rule,” meaning that any trip that doesn’t involve a substantial rest period, approximating eight hours in bed, doesn’t put the taxpayer in travel status for the purposes of this provision. Commuting and meal costs are ordinarily personal consumption expenditures, not business expenses.

Keep in mind that although a deduction, such as a meal, may not deducted under § 162(a)(2), it may still be deducted under § 162(a).

Hantzis v. Commissioner – CB 530; HB 372The taxpayer was a second-year law student at Harvard. She was unable to find summer work in Boston and instead took a job in New York. Taxpayer’s husband remained in Boston during the summer. The taxpayer deducted $3,204 from her tax return, representing the cost of meals, lodging in New York, and the transportation from Boston to New York. The court held no deduction because although the taxpayer did incur the expenses in the pursuit of a trade or business, the taxpayer was not away from her tax home, which was New York. The taxpayer had no business reason to maintain a home in Boston.

According to Rev. Rul. 99-7: CB 537, if a person does not have a place of business, for example a traveling sales person, the person cannot deduct any of their traveling expenses.

2. EntertainmentArguably, business is a social activity and seeking clients or customers often involves food, beverages, or entertainment. However, in addition to a business purpose, there is also some element of personal consumption.

Cohan v. Commissioner – p 539George Cohan often entertained actors, employees, and critics. He also traveled often. His expenses were substantial and at least some of them were deductible. However, he did not keep records. The tax court held that because he did not have any records, he could not take any deductions. The court of appeals reversed holding that “absolute certainty” is often not possible and a reasonable approximation should be made. If the estimate is conservative that is okay because it is the taxpayer’s fault.

As a result of cases like this,23 Congress enacted § 274. Section 274 acts as a limitation on § 162(a). Section 274 limits, conditions, or prohibits certain deductions that § 162 or § 212 would otherwise permit. Section 274(d) requires taxpayers to document their travel and entertainment expenses, overruling Cohan.

Overview of § 274:24

1) An activity which is generally considered to be entertainment, amusement or recreation, its expense may be deducted only if (a) the activity is directly related to the taxpayer’s business, or (b) the activity is associated with the conduct of the taxpayer’s business and it immediately precedes or follows a substantial business discussion. For an elaboration on the terms “directly related” or “associated with” see Treas. Reg. § 1.274-2(c) and (d). Generally, the entertainment must be of a sort conducive to a business discussion.

23 For an outrageous case see Sanitary Farms Dairy, Inc. v. Commissioner in which the court held that an African safari was a deductible business expense of the dairy, HB 399.24 For a nice chart, see HB 401.

30

2) Deductions for facilities used in connection with entertainment (such as yachts, clubs, and the like) are denied, unless the facility is used primarily for the furtherance of the taxpayer’s business, and was “directly related to the active conduct of such trade or business. § 274(a)(1)(B) and 274(a)(2).3) Section 274(b) limits the deduction for “business gifts” to $25 per recipient per year.4) Section 274(c) covers allocation between business and non-business expenses for foreign travel.5) ** VERY IMPORTANT ** Section 274(n) limits deductions for both types of deductible business meal expenses – travel and non-travel to 50% of the amount actually spent. Section 274(n) also applies to entertainment expenses.6) Section 274(e) gives several exceptions to § 2747) Section 274(d) is the substantiation requirement. If the employee is reimbursed for business meals, then he is not subject to these rules (rather the employer would be).

G. Patrolling the Business-Personal BordersSection 162 allows a deduction for business expenses. Section 262 disallows deduction of “personal, living, or family expenses.” Deciding what is business and what is personal is complicated and is manifested in the following areas.

1. Hobby LossesSection 183(a) disallows deductions for activities not engaged in for profit.

Keanini v. Commissioner – CB 546The taxpayers ran a dog breeding and grooming business. The taxpayers took deductions in connection with their “operation.” The IRS argued that they were not engaged in a dog operation for profit within the meaning of § 183(a). Under § 183(a), individuals are not allowed to deduct losses attributable to an activity not engaged in for a profit. The IRS argued that the dog breeding and grooming were separate activities and the breeding operation was not an activity engaged in for profit. The court held that the two activities were a single activity for the purposes of § 183 under Treas. Reg. § 1.183-1(d)(1), because there was a close organizational and economic relationship between the breeding operation and the grooming shop. The court next holds that the taxpayers were engaged in the dog operation with the objective of making profit. To be engaged in an activity for a profit, the individual has to first have an actual and honest objective of making a profit (it doesn’t matter if this expectation is reasonable). The court considered the nine factors listed below.

Treas. Reg. § 1.183-2(b) gives nine factors to consider in determining whether an activity is engaged in for profit:1) The manner in which the taxpayer carried on the activity2) The expertise of the taxpayer or his advisors3) The time and effort expended by the taxpayer in carrying on the activity4) The expectation that assets used in the activity may appreciate in value5) The success of the taxpayer in carrying on other similar or dissimilar activities6) The taxpayer’s history of income or loss with respect to the activity7) The amount of occasional profit, if any, which is earned8) The financial status of the taxpayer9) Whether elements of personal pleasure or recreation are involved

Section 183(b) restores deductibility for two categories of deductions. Section 183(b)(1) allows deductions that do not depend on any business or profit-seeking purpose, e.g. state and local property taxes against property not held for business or investment purposes. Section 183(b)(2) allows a deductions that do depend on profit-seeking purpose to the extent that they do not exceed the income from the activity (which is reduced by those deductions taken under § 183(b)(1)).

2. Vacation HomesTaxpayers who rent vacation or other homes which they also use for personal purposes are limited in the deductions they may take. Rental homes can be divided into four categories:1) Rental homes that are not used by the taxpayer for personal purposes at any time during the taxable year. The taxpayer make take deductions with respect to these properties under the usual rules under §§ 162, 212, 167, and

31

168.25 Under § 280A(d)(3), a taxpayer can rent a dwelling to any person (including relatives) for use as the tenant’s principal residence at fair rental and it will not be treated as using the dwelling for personal purposes.

2) Rental homes used for personal purposes for a period which does not exceed the greater of fourteen days, or 10 percent of the number of days during such year for which the unit is rented at a fair rental. Taxpayers can take deductions which are allowable without regard to the business use of the property (e.g. mortgage interest, property taxes, and casualty losses). Deductions which may be taken if they are attributable to property use in business (such as maintenance, utilities, depreciation, and casualty losses) may only be taken to a limited extent based on usage. The usage limit as to these deductions is that they may be taken only in proportion to the number of days the property is rented out, divided by the total number of days the property is used for rental and personal purposes.

3) Rental homes used for personal purposes for a number of days which exceeds the greater of fourteen days or 10% of the number of days during the year for which the unit is rented at a fair rental. These are subject to the same usage restrictions on deductions as units in category (2). In addition to the usage limit, units in this category are subject to an income limit. Business-type deductions, such as maintenance, utilities, and depreciation which meet the usage limit are still subject to the further income limit that they cannot be deducted to the extent that they exceed the gross rental income derived from renting the property less the deductions that would be allowed regardless of business use. In Bolton v. Commissioner, the court held that the ratio used for deductions that would be allowed regardless of business use is the number of days rented divided by the number of days in the year. This creates a smaller amount which is subtracted first from the income from the unit. This allows for more business expenses. The deductions allowed regardless of business use are not limited to the income, they can be taken no matter how much income the rental home generates.

4) Rental homes rented for less than fifteen days. If a taxpayer makes personal use of his vacation or other rental home and does rent it, but for less than fifteen days cannot take any deductions attributable to the rental use. However, the rental income so generated is excluded from gross income.

3. Home OfficeSection 280A provides rules for deductibility of expenses of a taxpayer using a portion of his home as an “office.” First, deductions that are generally allowed without regard to whether the taxpayer has an office in his home will continue to be allowed (e.g. mortgage interest, property taxes, and casualty losses). With respect to business deductions (such as maintenance expenses, utility expenses, rent, and depreciation) they are only allowed to the extent they are allocable to a portion of the taxpayer’s residence which is exclusively used on a regular basis (a) as the principal place of business for any trade or business of the taxpayer; (b) as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business; or (c) in the case of a separate structure which is not attached to the taxpayer’s residence, in connection with the taxpayer’s trade or business. If the taxpayer’s business involves him being an employee, he may only take business deductions attributable to his home office if the use of the home office is for the convenience of the taxpayer’s employer.

4. Education ExpensesEducation expenses are deductible if they (1) maintain or improve skills required by the individual in his employment or other trade or business or (2) meet the express requirements of the taxpayer’s employer, or the requirements of applicable law as a condition to the retention by the taxpayer of his employment or rate of compensation. Treas. Reg. § 1.162-5. Furthermore, after they meet either (1) or (2), the expenses will only be deductible if they (a) are not expenditures made by an individual for education to meet the minimum educational requirements for qualification in his employment or other trade or business; and (b) do not lead to qualifying the taxpayer for a new trade or business.

In Namrow v. Commissioner – CB 554, the court denied the deduction by the taxpayer of expenses for training in psychoanalysis. The taxpayer, a psychiatrist, argued that the training was merely improving a skill. The court held that it qualified the taxpayer for a new career.

25 §§ 167 and 168 relate to depreciation.

32

5. Work-Related ClothingThe court in Pevsner v. Commissioner – CB 560, sets out a three prong test for the deductibility of work-related clothing: (1) the clothing in question must be required as a condition of employment; (2) it must not be suitable for general wear; and (3) it must not be so worn. In Pevsner the court held that (2) is an objective test and the Yves St. Laurent apparel the taxpayer had to buy for work was suitable for general wear.

VI. Capitalization and Cost RecoveryA. Capitalization and Depreciation: The Basics

Under the “accelerated cost recovery system” (“ACRS) of § 168, the cost recovery schedule for a particular asset depends on three things: the total amount of cost to be recovered, the number of years over which the cost is to be recovered, and the rate at which the cost is to be recovered. Section 168(b)(4) provides that the salvage value is always treated as zero. Although § 168 requires straight line depreciation for buildings and a few other types of assets (see § 168(b)(3)) most assets are eligible for an accelerated schedule, under which larger deductions are allowed in the earlier years.

Under the 200 percent (or “double”) declining balance method, the first step is to calculate the percentage of cost the taxpayer could recover each year under the straight line method. The next step is to determine the rate which is double the straight line rate. That percentage is then applied each year to the unrecovered basis of the asset. The method is switched to straight line when straight line recovery of the remaining basis produces a larger deduction than continued use of 200 percent declining balance.

If an asset is not place in service at the beginning of year 1, § 168(d)(1) treats most assets as being placed in service in the middle of the year, with the result that only a half-year’s worth of depreciation is allowed for the first year. This is known as the half-year convention.

Under § 1016, the taxpayer’s adjusted basis is reduced by the amount of the deductions allowed under § 168. Section 1245 deals with gain from depreciable property. Section 1245 states that any gain that represents the recapture of overly generous ACRS deductions on tangible personal property will be treated as ordinary income. Section 1245 does not apply to real property.

Hypo: Taxpayer bought a car for $10,000. Depreciation of $6,160 was taken. The car has an adjusted basis of $3,840 when the car is sold for $12,000. $6,160 (the recapture of depreciation) is taxed at ordinary income and the other $2,000 could qualify as capital gain under § 1231.

Section 1250 applies to real property, but only if accelerated depreciation was taken, which has not been allowed since 1986. Under § 1(h)(1)(D), recaptured depreciation is subject to 25% tax. Gain above the recaptured depreciation is taxed at the capital gains rate (15%).

Section 1231 deals with the taxation of the sale of depreciable plant and equipment. Under § 1221(a)(2), depreciable property used in a trade or business is not treated as a capital asset (not eligible for capital gain treatment under § 1222). Under § 1231(a)(1), gains are treated as long-term capital gains. Losses are treated as ordinary. IRC § 1231(a)(2).26

B. What is Depreciable?Not every long-lived business asset is depreciable. Land is one asset which is nondepreciable. If a taxpayer acquires land and a building for use in his business, he must allocate his cost between the depreciable building and the nondepreciable land. The IRS has the position that art or antiques used in a business (such as paintings displayed in a lobby) are not allowed depreciation deductions. An intangible business asset is also eligible for depreciation (usually called amortization) if it will be used in the business for only a limited period, the length of which can be estimated with reasonable accuracy. See Treas. Reg. § 1.167(a)-3 (depreciated under straight line method over 15 years).

26 For a more in-depth description of § 1231, see HB 294.

33

Under § 197, taxpayers are allowed to recover the cost of a wide range of purchased intangibles, including goodwill and other “customer-based intangibles,” on a straight line basis over 15 years, without regard to the actual use life of the asset. With a few exceptions, § 197 does not apply to intangibles created by the taxpayer itself, such as self-created goodwill.

The IRC also permits the gradual cost recovery of exhaustible natural resources. Taxpayers can choose between two different cost recovery methods: cost depletion under § 612 and percentage depletion under § 613.27

C. What Costs Must Be Capitalized?1. Self-Produced Property

Commissioner v. Idaho Power Co. – CB 586The taxpayer used its own equipment and employees to construct improvements and additions to its capital facilities. The taxpayer on its books for the Federal Power Commission capitalized the construction-related expenses but for tax purposes claimed a deduction for depreciation under the depreciation schedules of § 167. The issue was whether the taxpayer could take a deduction for depreciation over the shorter life of the equipment or if instead the expenses had to be capitalized and depreciated over the longer life of the capital facilities constructed. The court held the expenses had to be capitalized. “Construction-related depreciation on the equipment is not an expense to the taxpayer of its day-to-day business. It is […] appropriately recognized as part of the taxpayer’s cost […] in the capital investment.”

2. INDOPCOINDOPCO, Inc. v. Commissioner – CB 592; HB 465Unilever was interested in buying INDOPCO. The largest shareholders of INDOPCO agreed if they could transfer their shares to Unilever tax free. Lawyers developed a plan. INDOPCO incurred fees from Morgan Stanley of $2.2 million in creating the merger. INDOPCO claimed a deduction for those expenses. INDOPCO argued that the test for capital expenditures is whether an asset was created or enhanced. No asset was created or enhanced here. The court held that those expenses should be capitalized. While an expenditure that creates or enhances a separate and distinct asset should be capitalized, it does not follow that only expenditures that create or enhance separate and distinct assets are to be capitalized. While the presence of a future benefit is not controlling, it is undeniably important in deciding if an expenditure is capital. The expenses of planning this merger created substantial future benefits.

In Rev. Rul. 92-80 – CB 596, the IRS ruled that advertising costs could be deducted as ordinary business expense under § 162 and did not have to be capitalized.

3. RepairsRev. Rul. 2001-4 – CB 600Treas. Reg. § 1.162-4 allows a deduction for the cost of incidental repairs that neither materially add to the value of the property nor appreciably prolong its useful life. Even a routine repair could be considered to prolong the useful life and increase the value of the property. The IRS holds that characterizing a cost as a deductible repair or capital improvement depends on the context in which the cost is incurred. Where an expenditure is made as part of a general plan of rehabilitation, modernization, and improvement of the property, the expenditure must be capitalized, even though standing alone, the item may be classified as one of repair or maintenance. In the ruling, the IRS held that repair of the airplane, although it cost $2 million, did not extend the life of the airplane nor make it worth more. Therefore, the repairs could be currently deducted.

4. Expenses to Create or Maintain a Business ReputationWelch v. Helvering – CB 606; HB 459Taxpayer was the secretary of a company engaged in the grain business. The company went bankrupt and was released from its debts. The taxpayer got a job to purchase grain on commission for another company. In order to re-establish relations with customers that he had worked with previously, he decided to try to pay off as many of the debts of the bankrupt company as he was able. The IRS argued that the payments were not deductible as ordinary and necessary business expenses under § 162 because they were capital expenditures for the development of

27 See CB 585

34

reputation and goodwill. The court held the payments were not deductible because (1) the payments were necessary but not ordinary; and (2) the payments were capital expenditures.

However, the court in Jenkins v. Commissioner – CB 609, allowed a necessary and ordinary business deductions for payments to investors of a failed restaurant venture. This can be distinguished from Welch in that Welch’s business was previously completely destroyed and he paid the money to completely rebuild goodwill while Twitty’s (the taxpayer in Jenkins) was only slightly damaged and he was paying to repair.

5. Job Hunting ExpensesThe IRS’ position is that job hunting expenses are currently deductible if the taxpayer is seeking new employment in the same trade or business in which he is currently employed. However, where the taxpayer is seeking his first job, or employment in a new trade or business, no current deduction is allowed. See Rev. Rul. 78-93 – CB 614.

VII. Tax AccountingA. Generally

There are two types of tax accounting: cash and accrual. Individuals are almost exclusively cash method taxpayers. The cash method includes something in income when the taxpayer receives it. The accrual method puts it into income when all events necessary to earn have occurred and there is reasonable certainty as to the amount. Taxpayers prefer the cash method because it is easier and income is deferred until it is received. However, accrual is thought to generally match income and expenses.

Gross Income = Total Sales – Cost of Goods SoldCalculating Cost of Goods Sold is difficult.Cost of Goods Sold = Opening Inventory + Purchases – Closing Inventory.

There are two methods of calculating Closing Inventory: FIFO and LIFO. Assuming that costs are rising, LIFO is better. Cost of Goods Sold is higher and you are showing less profit. Therefore, you are taxed less. However, LIFO causes your financial statements to show less profit. The Code mandates that you use the same inventory method for both tax and accounting.

B. Cash Method: Constructive ReceiptUnder the cash method, a taxpayer must include an item in income when it is actually or constructively received. Under the doctrine of constructive receipt, a taxpayer may not deliberately turn his back upon income and thus select the year for which he will report it. Under § 451, if a taxpayer has an unrestricted right to demand the payment of an amount, the taxpayer is in constructive receipt of that amount, whether or not the taxpayer makes the demand and actually receives payment. See the committee report for § 451 – CB 641.

C. Accrual Method1. All Events Test, Clear Reflection of Income, and Economic Performance

Ford Motor Co. v. Commissioner – CB 642In 1980, the taxpayer set up structured settlements in several settlements of personal injury or accidental death claims. Ford estimated their total payments would be $24,477,699. To cover the periodic payments, Ford purchased annuity contracts for $4,424,587. Ford claimed deductions in 1980 for $10,636,994, claiming that this would be Ford’s liability for the settlement. Ford included in income the amount received from the annuity contracts. The IRS claimed Ford’s method of accounting for the structured settlements did not clearly reflect income under § 446(b). The court held that the commissioner has broad discretion under § 446(b). The test for determining when an expense is “incurred” is the all events test. This test provides that an accrual method taxpayer must deduct an expense in the taxable year when all the events have occurred that establish the fact of liability giving rise to the deduction and the amount of the liability can be determined with reasonable accuracy. The court held that even if the “all events test” is met, the Commissioner still has the authority under § 446(b) to determine that a taxpayer’s method of accounting does not clearly reflect income. The court limited Ford’s deduction to $4.5 which was the cost of the annuity contracts. This is intuitively the correct result because $4.5 million is the present

35

value of Ford’s liability. If Ford had been allowed to deduct $10.5 million, Ford could have benefited. See CB 649 n.1.

Congress enacted § 461(h) which are “economic performance” rules. Under § 461(h), an accrual method taxpayer may not deduct an expense, even though the all events test has been satisfied, until economic performance with respect to such item occurs.

2. Early Cash Receipts of Accrual Method TaxpayersSchlude v. Commissioner – CB 650; HB 630The taxpayers operated an Arthur Murray dance studio. The customers signed contracts for dance lessons that were noncancellable. The contracts specified a number of lesson hours ranging from five to 1,200 (with some contracts providing lifetime courses). The taxpayers considered the payments on the contracts deferred income until the customers actually took a class or failed to take a lesson for one year. The IRS, using § 446(b), claimed the system was not clearly reflecting income and they had to include all at once. The court relying on American Automobile Association – HB 629, agreed with the IRS.

VIII. Tax PreferencesA. Tax Shelters

1. Passive Loss Rules of § 469The passive loss rules generally prohibit taxpayers from deducting losses from “passive activities” against either salary income or portfolio income (such as interest and dividends). A “passive activity” is defined as any activity which involves the conduct of any trade or business or § 212-type activity, in which the taxpayer does not materially participate. Passive activities always include rental activity, regardless of whether the taxpayer materially participates in the rental activity.28

The losses and credits generated from all such passive activities taken together can only be taken against the income and tax liability generated from such passive activities taken together. Any unused passive activity losses and credits are carried forward to the next year where they may be applied against passive activity income and tax liability for that year. This carryforward continues indefinitely.

Portfolio or investment income is not considered to be income from a passive activity for these purposes. If an activity changes from being passive to being active, any unused deduction allocable to such activity is offset against the income from the activity for the taxable year. If during a tax year, a taxpayer disposes of his entire interest in a passive activity or former passive activity, then the following rules apply: If all realized gain or loss is recognized, any loss from such activity which has not previously been allowed as a deduction is not treated as a passive activity loss.

In addition to the passive loss rules are the at-risk rules of § 465. Section 465 limits deductions from an activity to the amount the taxpayer has “at risk” in the activity. They take aim at non-recourse financing, an important part of tax shelters. You can’t take a deduction for more than you have at-risk.

2. Judicial Anti-Abuse DoctrinesEven in the absence of specific anti-shelter legislation, courts have used a number of common law doctrines to restrain the use of tax shelter strategies.

Knetsch v. United States – CB 686The taxpayer bought an annuity for $4 million. He paid $4,000 cash and signed a note for $4 million of nonrecourse loan for the balance. He borrowed at 3.5% interest to invest in an annuity with 2.5% interest. Each year, he had a return of -1%. At that time, interest was deductible. The real cost was $38,000 (after tax deduction), then he receives the 100,000 tax free. He made money on the transaction. The court held Congress didn’t intend the statute

28 A limited exception allows a taxpayer actively participated in rental real estate activities during the year to take up to $25,000 of net losses arising from that activity as a deduction against non-passive income.

36

to be used this way. It was a sham because absent the tax deduction, there was no way he could make money on the transaction. A transaction has to have substance and utility beyond the deduction which is generated.

There are two shame transaction doctrines:1) Transaction lacking economic substance – the transaction follows the letter of the law but no substance and utility2) Sham transaction – it really didn’t happen. There are no economic realities, just paper shuffling.

Rice’s Toyota World, Inc. v. Commissioner – CB 691To treat a transaction as a sham, for tax purposes, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists. The court held that the business purpose prong is a subjective test and the economic benefit prong is an objective test. In this case, the court held that the taxpayer did not have a business purpose and there was no economic benefit.

Some courts require both prongs and others will find a sham transaction if either prong is met.

B. Alternative Minimum TaxThink of this as running parallel to the other tax system. This is a minimum amount of tax everyone pays. The tax base is broad (not many deductions) and the rates are low. It affects: (1) people who are doing tax shenanigans; people with a lot of children (because it provides no exemption for children); and people in states with high state and local taxes.

Klaassen v. Commissioner – CB 699The taxpayer had ten children. Under the regular tax system, he got an exemption. Under AMT, there was no exemption. He argued that Congress didn’t intend AMT to apply. The court holds that the statute is unambiguous and congressional intent is clear.

We don’t have to calculate AMT.

IX. Taxation and the FamilyA. Tax Allowances for Family Responsibilities

There are two types of benefits for parents with dependent children. One type is based on the actual dollars paid for child care while parents are at work. The second type is based simply on the fact that the taxpayer is a parent of dependent children.

1. Allowances for Child Care Expensesa. Child Care as a Business Expense

It has long been settled that child care is not deductible as a business expense. It can be compared to the disallowance of commuting expenses.

b. The § 21 Child Care CreditSection 21 provides a credit equal to a percentage of a taxpayer’s child care expenses, if the expenses are “incurred to enable the taxpayer to be gainfully employed.” Expenses eligible for the credit are capped at $3,000 for a taxpayer with one “qualifying individual” (generally a child under the age of 13 or another individual unable to care for himself) and at $6,000 for a taxpayer with two or more qualifying individuals. For a taxpayer with AGI of $15,000 or less, the credit is 35% of the credit-eligible expenses. The rate of credit is reduced by one percentage point for each $2,000 (or fraction thereof) by which AGI exceeds $15,000, but the credit is never reduced below 20%.

It seems to be the intent of Congress to use the tax system to subsidize the cost of child care for working parents. By only subsidizing a percentage, the taxpayer has some incentive to get child care they can afford. If it was a dollar for dollar credit, everyone would get the Porshe of child care.

c. The § 129 Dependent Care Assistance Exclusion

37

Section 129 provides an exclusion for “dependent care assistance” received by an employee from his employer, if the employer has a qualifying “dependent care assistance program”. The exclusion is subject to a ceiling of $5,000 regardless of how many children the taxpayer has. This not only covers an employer-operated on-site child care facility, but it also covers cash reimbursements of employees’ child care expenses. A taxpayer cannot use the same dollars of child care expenses to generate both an exclusion under § 129 and a credit under § 21.

2. Child Tax Benefits Not Based on Expendituresa. Exemptions

Section 151 allows a taxpayer to claim one personal exemption for himself (two exemptions for a married couple filing a joint return) and an additional exemption for each dependent. The personal and dependency exemptions serve two functions. First, they work together with the standard deduction to prevent the imposition of income tax liability on persons living at or below the poverty level. The second purpose is to adjust tax liabilities for differences in family size across a wide range of income levels. Section 151(d)(3) phases out exemptions for upper income taxpayers. In the case of a child of divorced parents, § 152(e) generally allocates the dependency exemption to the parent who has custody of the child for most of the year, but the custodial parent can waive the right to the exemption in favor of the non-custodial parent. The § 24 child credit follows the allocation of the exemption.

b. The Child CreditThe § 24 child credit is in addition to § 151 rather than a replacement. The credit is independent of the taxpayer’s marginal rate. To calculate: multiply $1,000 by the number of the taxpayer’s “qualifying children.” The credit is phased out for higher income taxpayers, beginning at $110,000 for married couples filing joint returns. The tax credit is non-refundable meaning if the credit is for more than the tax liability, the remainder is simply lost.

c. Head-of-Household StatusA single parent who lives with one or more dependent children will usually qualify as a head of household for purposes of the income tax. Head-of-household is entitled to a substantially larger standard deduction than that available to other unmarried taxpayers. In addition, a head of household pays tax under a § 1 rate schedule with wider brackets than the § 1 rate schedule for other unmarried taxpayers.

B. Income Tax Treatment of MarriageLucas v. Earl – CB 733The taxpayer and his wife made a contract to divide all income equally. They then filed separate returns (thereby reducing their income tax liabilities).29 The court held that income is taxed to the earner.

Poe v. Seaborn – CB 734This was in a community property state. The husband and wife each reported half the income and half the deductions on their returns. The court held this was okay because unlike Earl this was a community property state. As such, half the income becomes immediately vested in the other spouse.

The opposite results of these cases based on whether a state was common law property or community property caused turmoil. States began to change to community property states for the benefit of their citizens. In 1948, Congress allowed a joint return.

C. Income Tax Consequences of DivorcePayments meeting the definition of alimony are taxable to the payee under § 71(a) and are deductible by the payor, § 215(a). Under § 62(a)(10), the deduction is allowed in arriving at the AGI, so it is available even to a payor claiming the standard deduction.

Another divorce tax planning question is which ex-spouse should claim the dependency exemption for a child of the marriage. Under § 152(e)(1), the default rule is that the custodial parent is entitled to the exemption; however, the custodial parent can waive the exemption in favor of the noncustodial parent. Section 24(c)(1) provides that the child tax credit goes to the parent who is entitled to the dependency exemption.

29 Note that this was before there was a joint return.

38

There are three reasons why one ex-spouse might make transfers to the other: (1) to satisfy a continuing obligation of spousal support; (2) to support children of the marriage living with the other parent; and (3) to settle claims relating to marital property rights. The income shifting rules of §§ 71 and 215 only apply to spousal support.

Two aspects of the § 71(b) definition of alimony are designed to weed out property settlements from alimony. First, § 71(b)(1) provides that only payments “in cash” can qualify as alimony. Second, § 71(b)(1)(D) provides that payments cannot qualify as alimony if the payor spouse would be required to continue to make payments even after the death of the payee spouse.30

If annual alimony payments decrease sharply during the first three post-separation years, then the tax benefit rule principles will apply in the third year. See CB 748 and § 71(f).

Under § 1041(a), no gain or loss is recognized on any transfer of property to one’s spouse, or to one’s former spouse if the transfer is “incident to the divorce.” The unrecognized gain or loss does not disappear. Instead, § 1041(b)(2) gives the transferee spouse a basis in the property equal to the transferor’s adjusted basis.

D. Earned Income Tax CreditThe earned income tax credit (“EITC”) is set forth in § 32 of the Code and can be understood as serving the goal of increasing the after-tax incomes of low-wage workers with family responsibilities. The EITC is refundable. The amount of the credit depends in part on the number of the taxpayer’s qualifying children. The maximum credit is $4,140.31

X. Identifying the Proper Taxpayer (Attribution)A. Earned Income

In Lucas v. Earl – CB 733, the Supreme Court held that earned income must be taxed to the earner even if the earner is not the consumer: The “fruits” may not be attributed to a different tree from that on which they grew.” For example, a taxable fringe benefit is included in the income of the person performing the services in connection with which the fringe benefit is furnished.

B. Income from PropertyTaft v. Bowers – CB 815A purchased 100 shares of stock for $1,000. The stock appreciated to $2,000. A gave them to B who sold the stock for $5,000. The IRS argued that B owed income tax on $4,000 ($5,000 - $1,000 basis). B argued that he owed income tax on $3,000 (the appreciation during B’s ownership). B argued that Congress didn’t have the power to tax the appreciation before B received the stock. The court held that if A had sold the stock instead of giving it away, A would have been taxed on the gain. A couldn’t keep from being taxed by giving the stock away. Congress has the power to require the donee to accept the position of the donor (in this case, the basis of $1,000).

Section 1(g) provides that the investment income of a child under the age of 14 is taxed to the child, but that it is taxed at the marginal tax rate of the child’s parents. Taxing the income at the parents’ marginal rate takes the tax fun out of making gifts of investment property to young children.

Under § 7872, in the case of a “gift loan” (defined as a loan bearing a below-market rate of interest when the forgoing of interest is in the nature of a gift) the statute creates a deemed interest payment from the borrower to the lender. The amount of the deemed interest payment is the difference between interest at the applicable federal rate and the actual interest charged. The deemed interest is taxable to the parents. The deemed interest may be deductible by the borrower.32

30 The book mentions a possible potential for malpractice liability here, if the divorce instrument fails to say anything about whether payments would continue after death and a court interprets the instrument to require continued payments in the case of the payee’s death.31 See CB 756 and HB 639.32 See HB 345

39

XI. Capital Gains and LossesJustifications for capital gains and losses are:33

1) Capital gains are capital, not income (“No responsible commentator defends favorable capital gains rates as a concession” that capital gains should not be taxed at all.)2) Inflation (this is an extremely crude method of inflation adjustment)3) Bunching4) Incentives5) Lock-in and Laffer curve

A. Mechanics of Net Capital Gain Computation1. Long and Short Term Capital Gains and Losses

Only capital assets held for more than one year can qualify for favorable treatment.34 Generally, a taxpayer’s holding period includes the holding period of prior owner(s) of the capital asset if the asset was acquired in a transaction in which recognition of the prior owner’s gain or loss was deferred by operation of law. See § 1223. Under a special holding-period rule applying to transfers at death, even property that receives a new basis in the hands of an heir under § 1014 is treated as though the heir had held the property for more than one year from the moment she receives it. IRC § 1223(11). Property held for one year or less generates “short-term” capital gains or losses.

2. Netting of Long and Short Gains and LossesCB 8551) Long-term gains are netted against long-term losses.2) Short-term gains are netted against short-term losses.3) If the results of the first two netting procedures have the same sign, then the taxpayer has that amount of each type of net gain or loss, and each is treated accordingly. But if the results of the first two netting procedures have opposite signs, those two outcomes are netted against each other. This final result has the character of whatever type of gain or loss “sticks out” after the netting procedures.

This process is described in § 1222.

Basically, short term losses can be used to offset long-term gains (that is bad) and short term gains can offset long-term losses (that is good).

3. The Several Capital Gains RatesIf your net capital gain is from … Then your maximum capital gain rate is . . .Collectibles Gain 28%Unrecaptured § 1250 gain 25%Other gain and the regular tax rate that would apply is 25% or higher

15%

Other gain and the regular tax rate that would apply is lower than 25%

5%

Collectibles taxed under the 28% rate include works of art, rugs and antiques, stamps and coins, metals and jewels, alcoholic beverages, and anything else that the Secretary of the Treasury decides to include in this category.

Section 1202 gains (28%)This is a special category of small business corporate stock. The basic rules of § 1202 allow exclusion of half of the gain from sale or exchange of this stock (this means that the effective rate is 14% of the entire gain).

Unrecaptured § 1250 Gain (taxed at 25%)

33 See CB 85034 For the definition of a capital asset, see § 1221.

40

Section 1250, which applies to dispositions of depreciable real property, recapures only the excess of depreciation claimed over the allowable straight-line depreciation.

4. Netting the Special Rate CategoriesIf the taxpayer has a net short-term capital loss and net long-term capital gains, the statute (which is pro-taxpayer) mandates netting the loss first against the category of gain that would be more highly taxed.

B. Limitations on Deductions of Capital Losses1. Rationale

Taxpayers have a good deal of control over the timing of their capital asset transactions. If there were no limitations on loss deductions against ordinary income, many people would be able to use their control of their realization events to offset income with realized losses, and thus to pay little or no tax.

2. The Capital Loss Limitation RuleSection 1211, for noncorporate taxpayers, only allows capital losses up to the amount of capital gains in the same year, plus $3,000 against ordinary income. Corporate taxpayers can deduct losses only to the extent of gains in the same year.

3. A Big Exception for Small Business StockSection 1244 allows an exception to the loss limitation rules with respect to investments in small businesses. Qualifying losses are allowed up to $50,000 per year (or $100,000 for a couple filing joint return) on the sale of stock of a corporation that was capitalized with less than $1 million of capital contributions. See § 1244.

4. Capital Loss Carryback and CarryoverUnder § 1212, corporate taxpayers may carry back those capital losses for up to the three preceding taxable years, to offset any net capital gains the corporation might have enjoyed in those prior years. If the losses cannot be absorbed by prior gains, then those losses may be carried over to any of the five taxable years following the year the loss was sustained.

For noncorporate taxpayers, there is no carryback provision. However, losses that are nondeductible because of the § 1211 limitations may be carried over to future years indefinitely.

C. Definition of a Capital Asset35

Capital assets are defined in § 1221(a) by exclusion.

1. Property Held for Sale to CustomersUnited States v. Winthrop – CB 861The taxpayer inherited property. He subdivided the property, graded and paved the streets, and installed electricity and water facilities, all at the taxpayer’s expense. He sold the properties without any advertising. The sales of the properties was his main work during the time. The taxpayer reported the profits as capital gains. The IRS argued the land was held for sale in the ordinary course of business; therefore, the gain was not a capital gain under § 1221. The trial court looked at seven factors: (1) the nature and purpose of the acquisition of the property and the duration of the ownership; (2) the extent and nature of the taxpayer’s efforts to sell the property; (3) the number, extent, continuity and substantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devoted to the sales. The court holds that the ultimate determination of whether the property was held for sale to customers is a determination of law and therefore, the decision of the court below is not subject to the clearly erroneous standard. The court overturns the court below, holding that the property was held for sale to customers and therefore not a capital asset.

2. Property Used in a Trade or Business35 The fight really centers around § 1221(a)(1).

41

Corn Products Refining Co. v. Commissioner – CB 869The taxpayer was a manufacturer of starch, sugar and their by-products which were made from corn. In 1937, taxpayer began buying corn futures.36 The taxpayer’s futures transactions were in the nature of hedging. The taxpayer was not looking to make a killing in the commodities markets but rather sought to protect its business operations. Corn futures were not strictly speaking, inventory or stock in trade held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. Taxpayer was not in the business of selling corn futures. Taxpayer argued that the corn futures were a capital asset. The Supreme Court felt the purpose of Congress was to deny capital gain or loss treatment to the profits and losses arising from the everyday operation of a business. The Court held the taxpayer had ordinary gain and loss on its corn futures transactions.

In Corn Products, the Court says “the definition of a capital asset must be narrowly applied and its exclusions must be interpreted broadly.” The question after the opinion was which one the court based its opinion on.

The Supreme Court answered this question in Arkansas Best Corp. v. Commissioner – CB 873. The Court dealt with a case in which stock was received by the taxpayer from a troubled bank in exchange for the taxpayer making investments in the bank. The investments were designed to preserve the taxpayer’s reputation by keeping the bank from failing. The Court held the loss on the sale of the stock was capital. The Court said Corn Products did not create a common law exception to capital loss treatment, but instead interpreted the inventory exception broadly.

D. Sale or Exchange RequirementSection 1001 requires computation of gain or loss on any “sale or other disposition.” However, the definitions of capital gains and losses speak of a “sale or exchange.” IRC § 1222(1)-(4). In Helvering v. William Flaccus Oak Leather – CB 878, the taxpayer’s property was destroyed by fire. The taxpayer received compensation from an insurance company. The taxpayer treated the insurance proceeds as capital gain. The commissioner said they were ordinary income. The Supreme Court held they were ordinary income because the statute says “sales or exchange.” This was not either.

On these same facts today, § 1231 would change the result. See CB 880 n.2.

E. Substitutes for Future Ordinary IncomeHort v. Commissioner – CB 882Taxpayer leases a property to an insurance company for $25,000 per year for 15 years. The depression hits and the market for leases drops. The insurance company pays $140,000 to cancel the lease. The taxpayer claims the present value of the lease was $161,000 and therefore, he had a loss of $21,000. The problem is he never paid tax on the $161,000; therefore, he had no basis. The court holds that it is a substitute for ordinary income (substitute for rental payments).

36 A commodity future is a contract to buy a fixed amount of the commodity at a fixed price at a future date. The purchaser of such a contract is said to be “long” and benefits from a rise in the price of the commodity. The seller of such a contract – who has thus agreed to sell the commodity at a fixed price on a future date – is said to be shrot and benefits form a drop in the price of the commodity.

42