Taxation OutlineProfessor Mark Gergen

Fall 2007

Income Intro

Goals of Tax: economic growth, distribution of burdens/benefits of government, raise revenues to fund government

Computation (individuals): ((gross income (§61) – above the line deductions (§62)) – below the line deductions (§151, 63, 67) x tax rates (§1)) – credits

Above the line: business expenses Below the line: standard or itemized deductions (some subject to 2% floor), personal and

dependency exemptions Credits are worth the same to all taxpayers, deductions are worth more to higher-bracket Ts

Computation (corporations): gross income – all allowable deductions Criteria for Evaluating Taxes

Equity: those with greater ability to pay taxes should pay more tax (vertical); those with equal ability to pay taxes should pay equal taxes (horizontal)

Efficiency: tax should draw as much wealth from the country as possible without harming people. It should interfere as little as possible with economic behavior (unless we want to interfere). Favors taxing inelastic things, e.g. head tax.

Simplicity/administrability: the tax which each individual is bound to pay ought to be certain, and not arbitrary. System should be easy to use/apply.

Compensation, defined IRC §61: “all income from whatever source derived,” including the enumerated items Haig-Simons: consumption plus change in wealth Eisner v. Macomber: gain derived from capital, labor, or both combined Glenshaw Glass: undeniable accessions to wealth, clearly realized, and over which the taxpayers

have complete dominion. (windfalls, punitive damages are taxable as income) Old Colony Trust Co.: where employer pays employee’s taxes, the amount paid is taxable as income

to the employee. Federal income taxes are imposed on tax-inclusive basis: amount of tax is included in the amount

of taxable income to which rates are applied. re = ri/(1 – ri) and ri = re (1 + re)

how tax disputes are litigated: tax court (not jury trial, specialist judges)

no prepayment of deficiency (government is suing T) district court (factual question, jury trial, non-specialist judges) – taxpayer is better off in district

court if he has a weak case cost: must pay deficiency in advance (T is suing for return of money)

appeal from either goes to US Court of Appeals (non-specialist judges) no penalty (beyond back taxes and interest) unless argument was unreasonable

Alternative Tax Bases Income: income from labor and capital; includes savings and consumption. More comprehensive

measure of ability to pay. Inhibits saving. Fairness argument stressed. Tax both when $ is earned and on returns from savings.

Wages SS tax up to $80k, Medicaid. Consumption: excise taxes, retail sales taxes, VATs. Exempts savings. Treats equally people who

consume identical amounts over their lifetimes. Efficiency argument stressed. Wealth: imposed on capital accumulation. Estate and gift taxes, local property tax.

Wage tax Cash flow consumption tax Income tax1

w*(1-t)*(1+r) w*(1+r)*(1-t) w*(1-t)*(1+r*(1-t))T earns $100, pays $40 in taxes, invests $60, and has $66 in year two

T earns $100, which she invests. This grows to $110, on which T pays $44 in taxes, leaving T with $66 in year two.

T earns $100, pays $40 in taxes, invests $60, earns $6 on which she pays $2.40 in taxes, and has $63.60 in year two

w=wage ($100)

t=tax rate (40%)

r=rate of return on savings (10%) Tax Expenditures: revenue losses attributable to provisions of the federal tax laws which allow a

special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability. Tax expenditure versus proper definition of income (“expenditure” requires knowing the “ideal” tax) Alternatives for tax expenditures:

Deduction: value varies with marginal tax bracket Credit: same value to all Ts, but no value to those who do not pay taxes. Direct subsidy: same value to all recipients. Harder to hide than a tax rebate, and only good for

one year, so politicians prefer tax approach. Deadweight loss for those who would engage in the activity that Congress wants to encourage

regardless of the tax expenditure. No increase in the beneficial activity, but loss of revenue. Also deadweight loss for taxpayer who gets the deduction at $2000 but the activity is otherwise worth only $1800 to him. Deadweight loss of the difference ($200) plus the deduction ($300).

Largest: employer-provided health insurance, pensions Health insurance subsidies through deductions or exclusions gives the greatest break to the rich.

Unemployed, part-time, etc. have no insurance. Huge expenditure with bad results. (We would not lose any tax revenue on health insurance for low-income Ts because they don’t pay taxes anyway, but they still aren’t covered.)

Fringe Benefits In-kind benefits transferred to an employee (additional compensation or essential to job). Many are

not taxed. Employer-provided health insurance, payments for injury/sickness are not taxable to employee.

Benefits paid for medical expenses, permanent disfigurement/disability are not taxed to employee. Sick pay or pay in lieu of lost wages is taxed. (§104, 105, 106)

Retirement income: employer may deduct amounts contributed to plan, employees only taxed on distribution (§401-04, 410-16) 401(k), Keogh, IRAs

Life insurance: income to employee, unless beneficiary is employer or a charity Moving expenses: reimbursement is deductible to the extent it could have been deducted if paid

directly (§132) Dependent care: excluded, $5k/yr limit (§129) Educational benefits: excluded, $5250/yr limit (§127) Cafeteria plans: employees choose from a group of taxable and non-taxable fringe benefits §132 benefits: no-additional-cost service, qualified employee discount, working condition fringe, de

minimis fringe, qualified transportation fringe, qualified moving expense reimbursement, qualified retirement planning services

Evaluation: Equity: fringe benefits more available to higher-paid Ts; incentive to use nontaxable fringe

benefits increases with marginal rate (but employer may provide fewer fringes, accounting for tax benefit)

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Efficiency: changes T behavior, may produce deadweight loss (employer gives $5k airfare benefit, employee at 35% rate will take it even if it’s worth $4k to him)

Simplicity: difficult to distinguish additional compensation from benefit essential to job. Deadweight loss: people who would have more marginal benefit than marginal cost are not

choosing the good/service, or people who would have more marginal cost than benefit are choosing it. Costs to society created by an inefficiency in the market. Loss in welfare with no concomitant rise in revenue.

Work-Related Fringe Benefits (§132)

Problem of how to treat these. Don’t want to avoid taxing because employers will offer more in-kind benefits and people will take them if they’re worth the value discounted for the employee’s marginal rate (e.g. $1000 gym membership taken if worth $601 for T in 40% bracket). Efficiency/deadweight loss problem. And inequitable because T with in-kind benefit now has more money to pay tax because he didn’t buy the benefit himself. But very difficult to tax in-kind benefits (administrability).

Solution: don’t tax benefits whose primary/substantial benefit accrues to the employer. §132: certain fringe benefits not included in income: no-additional-cost service, qualified

employee discount, working condition fringe, de minimis fringe, qualified transportation fringe, qualified moving expense reimbursement, qualified retirement planning services. Nondiscrimination (to avoid hiding income to wealthy employees), line-of-business (e.g.,

hotel employee taxed on free plane ride) requirements for some of these. Nondiscrimination doesn’t apply to on-site athletic facilities so upper class don’t have to share gyms with lower class.

Since these are subject to a floor, it’s better to get employer reimbursement than to use the exclusion

Corruption: $175/month for private transportation, $100/month for public. Ts were used to this benefit and Congress couldn’t change the world so rapidly.

Administrability: no reason to include working condition fringe if it would later be deductible (although subject to 2% floor); cost of accounting for de minimis fringe is greater than increase in tax revenue

Subjective devalution: T values the benefit less than employer/payor, so shouldn’t be taxable on the amount employer/payor was willing to pay

Benefits not from employers Gotcher: where the trip primarily benefited VW, the airfare was excludable from Gotcher’s

income Employer-provided meals & lodging (§119)

Meals/lodging furnished to T, spouse, dependents excluded from income if provided for employer’s convenience AND [standard]

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provided on business premises [bright-line rule] Reg. 119-1: “furnished for a substantial noncompensatory business reason of the employer” If provided at work, there is subjective devaluation by employee. More likely to be for

employer’s benefit than for employee’s. Kowalski: only meals provided in-kind are excluded, not reimbursements for meals

Exception: §132(d)(2): money is only occasional, employee works overtime, and employee eats meal during overtime period

Receipt of property as compensation (§83) Property included as income when it is no longer subject to substantial risk of forfeiture (e.g.

employee stays on past a certain date) If no restrictions, T taxed on any value over what he paid for it (e.g. taxed on $60 if paid $40 for

$100 of stock) Employer cannot deduct until employee includes property in income

Indirect/substitute taxation: benefit to employee is offset by delay in employer’s deduction 83(b) election: employee can choose to be taxed while the property is still subject to forfeiture

T takes risk of forfeiture (no loss if forfeited) and gets lower capital gains rate on dividends Can’t be taken on an option unless options are publicly traded and have readily ascertainable

fair market value (T will undervalue the property, take the election, and pay lower tax) Imputed income: benefits derived from labor on one’s own behalf or the benefits of property ownership

Usually not treated as income (administrability: where to stop? If I paint my nails, do I have imputed income of manicure cost?)

Largest source: domestic services. Also owner-occupied homes (if T rents it, he is taxed, but if he lives in it, he is not).

Deadweight loss: if T is subject to 40% marginal rate, she must make 40% more than the value of her domestic services to justify going back to work. E.g. if services would cost $12k, she must make $20k. If she can only earn $18k, there is $6k deadweight loss.

Exchange of services: §1.62(2)(d)(1) – taxable at FMV of services received. If FMV only known for one, assume exchange was equal.

Gifts, bequests, prizes, scholarships (§102) Value of property acquired by gift, bequest, devise, inheritance is excludable Justifications: 1) family is taxable unit, so transfer among it should not be taxable; 2) we should

create incentives to give gifts because they increase the utility of the gift (both donor and donee get some benefit from the gift); 3) unadministrable to tax because most would be unreported

Duberstein: gift is a transfer made “from a detached and disinterested generosity” and not from a sense of moral or legal duty or from an anticipated benefit.

§102(c): employer gifts to employees are not excludable §274(b): gifts >$25 are non-deductible by donor. If donee excludes, donor cannot deduct. If

donee includes, donor can deduct (business expense). Although they could take inconsistent positions ($800 bottle of wine was a gift vs. business expense to build goodwill)

Tips are taxable Oscar goodie bags are taxable political contributions are not taxable to candidate if used for political campaign, family member

and government support payments are excludable Prizes/awards are taxable unless transferred to charity (and given in recognition of achievement,

no future services required, and no action taken to enter contest) (§74) Bequests are excludable (§102) if it meets the Duberstein standard. Scholarship/fellowship excludable if used for qualified tuition and related expenses (§117).

Cannot be quid pro quo for services rendered. Basis (§1001)

§1001: gain or loss on disposition of property = amount realized - basis. Basis is already-taxed wealth.

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§1012: basis is cost that has not been recovered or deducted Cost to T Fair market value of property received by T

Basis is recovered as an asset is used up by depreciation and amortization. Exception: debt-financed investment. T gets basis despite not already being taxed, on the

assumption that the debt will be repaid with after-tax income. Where two parties exchange assets, they both realize gain or loss; they only trade basis if it is a gift

(non-recognition) Gift (inter vivos): basis is transferred if there is a gain; donee gets donor’s basis. Basis is value at

time of gift if there is a loss (to avoid loss shifting). If donee doesn’t know donor’s basis, basis is FMV. (§1015)

Gift (heirs): heir’s basis is FMV at donor’s death. (§1014). Step-up in basis. Step-down if there is a loss. Incentive to keep appreciated assets until death and sell depreciated ones.

Allocation of basis If part of an asset is sold, can’t treat the price as all recovery of basis (too much incentive to

carve up assets) and can’t treat as all gain (too much incentive not to carve up). When a portion of property is sold, the basis must be divided among the parts. If the part sold is

more valuable than the part retained, the basis should be divided equitably (§1.61-6). FIFO for assets of the same kind (if T cannot distinguish them) Part-gift, part-sale (gain): transferee’s basis is the greater of the amount paid or the transferor’s

basis (§1015(d)). If loss, transferee’s basis is the FMV on transfer. If to charity: basis allocated in proportion to respective values

Asset with periodic yield: yield is all income for nonwasting asset (bank account, land, stock, bond); basis is apportioned for wasting asset (loan repayment, depreciating assets [vehicles, buildings], premium paid for above-market lease/interest)

Realization requirement Justification: administrability. Hard to value assets every year, and Ts may not have liquidity to

pay an accretion tax. Distortions: incentive to keep gain assets and sell loss assets. And assets that don’t deliver gains

until realization get the time advantage of money. Equity problem: A gets $1k in salary and is taxed, B’s property increases in value $1k and is not

taxed. B gets time value of money. If T gets money he must later return, he is taxed on receipt and the return is deductible when

paid. Eisner v. Macomber: Revenue Act of 1916 held unconstitutional. T’s stock dividends are not

income because they are not “derived from capital.” T has same value invested and no liquidity to pay taxes because nothing was sold. If T has option to take cash or stock dividend, he will be taxed on the stock dividend.

Bruun: when lessee makes leasehold improvements, landowner has income equal to the remaining value of the improvements when the lease terminates. Reversed by §109. Distortion for accepting leasehold improvements in lieu of rent, but real estate owners have a

very strong lobby Cottage Savings: realization event when mortgage loans are exchanged. Properties are

“different” if their possessors have different legal entitlements. So S&Ls could realize a loss without sustaining book loss.

Windfalls Income Cesarini: $4k found in piano was all taxable. No basis is allocable to the $4k because the money

is not associated with a decline in value of the piano.

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No liquidity problem where money is discovered. If asset with estimated value is discovered, no income until sale. No basis in the asset.

Haverly: when T donates books to charity, he must report their value as income Annuities & life insurance (§72, §101)

Annuity: payment in return for a promise to pay certain sums at intervals (esp. if payment period measured by lifetimes) Amount received – amount paid = income to annuitant

If T bought the annuity with pre-tax account (IRA), then annuity payments are all income. Only middle-income Ts buy annuities, and they fund with IRAs, so there is no real world application.

§72: portion of each payment is treated as recovery of investment and a portion treated as taxable return Another approach: Burnet v. Logan – all payments are recovery until that amount is reached,

then everything is income Equity concern: Delay in taxation of interest gives annuitants the time value of money, and

usually only high-income Ts can use them. Annuities are better than savings accounts because economic accrual of interest (plus withdrawal of some portion of the investment) causes there to be more interest (and more tax) at the outset.

Insurance: amounts paid by reason of the death of the insured are not taxed (§101) Premiums paid are not deductible Proceeds received upon termination of cash value policy (not death) are taxable if they exceed

the cost of the policy Types of insurance

Term insurance: pay premium in return for specified sum paid to beneficiaries upon death Ordinary life insurance: pay uniform annual premium through life; policy matures at death Universal life insurance: purchase contract for life insurance and deposit sum with insurance

company Variable life insurance: premiums are invested by insurance company and proceeds are

payable on the death of the insured; value depends on the success of the investments. Inside interest buildup: the interest that the company makes on the difference between the

premium paid and the amount that covers the risk. E.g. $300 premium with $60 to cover risk leaves $240 invested, which makes $14.40 inside interest buildup (6% rate) Inside interest escapes tax

Once cash balance, including inside interest, reaches the policy amount, insured should get higher policy or distributions

Advantage of whole: after awhile, premiums are paid from inside interest, not after-tax dollars; if surrendered before death, interest income was still deferred and T gets basis in the full cost of the insurance, including the portion that covers the company’s risk

La Gierse: can’t combine annuity and life insurance to avoid tax (e.g. pay $100k for $100k death benefit and $6k yearly annuity payments). Some of the $6k will be treated as a recovery of basis but it’s really interest on a loan. Substance over form. Some risk is required for insurance proceeds to be excluded. Can be done legally by purchasing separately

Tax benefit may not make whole/universal life a better tax investment because companies charge high fees

Loans & discharge of debt Borrower: No income on receipt of loan, no deduction on payments of principal. Lender: No

deduction on making loan and income on recovered payments of principal No income because cash is offset by liability to lender

When paid by another, either taxable under Old Colony (as compensation) or nontaxable gift

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When loan is cancelled for less than face value, borrower has income (§61(a)(2) discharge of indebtedness) Income is no longer offset by liability

Contested liability doctrine: if T disputes the amount of a debt, the settlement is treated as the actual loan amount. No income to T on discharge of debt. This reflects the true value of the debt to the parties.

Exception to rule that relief from debt may not be “cancellation of debt” income: E.g. employer loans employee for house, forgives part each year that employee works. This is

regular compensation, so it is not subject to the COD exceptions (insolvency, etc.) Exceptions to rule that cancellation of debt results in income: (§108)

Debtor insolvency: debt cancellation is excluded to the extent of insolvency (§108(a)). T must reduce other tax benefits (e.g. net operating loss carryovers) or the basis of his

property by the amount of the debt cancellation. Lost deductions: no income if discharge of debt would result in a deduction (§108(e)(2))

E.g. employer owes employee compensation, employee agrees to take less than what is owed Purchase money debt reduction/purchase price adjustment (§108(e)(5))

Debt must arise out of the purchase of property and debt must still be held by seller/lender (n/a if sold debt to another). Debtor takes reduced basis in the property.

Discharge treated as gift: only in noncommercial setting (§102) Student loan forgiveness: student must be required to work in certain professions for a time

Zarin: Tax Court held gambler had income on cancellation of his gambling debt; Third Cir. reversed because the loan was unenforceable under the applicable state law. Gambling losses only deductible to the extent of gambling income.

Real estate tax shelters Recourse debt: borrower is personally liable; nonrecourse debt: lender can only be repaid from the

assets securing the debt T gets basis in an asset if it is financed by debt, regardless of whether the debt is recourse or not

Argument that T should not get deductions funded by nonrecourse debt because he does not bear the economic risk of loss.

Where the debt is recourse, debt forgiveness is ordinary income (unless a §108 exception applies) if basis is greater than FMV of property, T takes a capital loss in that amount if basis is greater than FMV of property, T has capital gain on that amount

Where the debt is nonrecourse, debt forgiveness is part of the amount realized upon disposition of the property, which results in capital gains. Capital gain = debt – basis in property exchanged

COD income is ordinary. Gain/loss on disposition of real property is capital. Tufts: T who exchanges property for relief of nonrecourse debt has capital gains on the difference

between the debt and his basis in the property. T must treat nonrecourse mortgage consistently when he accounts for basis and amount realized.

Tax shelter: A, which cannot take advantage of a deduction, sells property to B, which can. B takes deduction and rents the property back to A. The rental payment is equal to the amount of principal and interest due on the note. B gets the time value of money by getting early deduction offset by later income (“phantom gain”/ “Tufts gain”). A usually gets some payment as incentive to engage in the shelter. B also gets conversion of ordinary income into capital gain where the tax shelter involves lender taking property to resolve debt.

Estate of Franklin: buyers have no basis in the property when they could not show the nonrecourse debt-financed purchase price was at least approximately equivalent to the FMV of the property. Ts had no investment in the property because they had inflated the purchase price and it was mostly due at the end of the leaseback. Depreciation can only be taken where T has invested in the property; no investment where there is no real obligation to purchase (debt is nonrecourse and T could just

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default). A loan should not increase basis where it is unclear whether the borrower will ever actually make principal payments. Contingent liabilities excluded from basis until payment is made

Pleasant Summit (3d Cir.): where nonrecourse debt greatly exceeds property’s FMV, T may deduct depreciation and interest attributable to the portion of the nonrecourse debt that did not exceed the property’s FMV.

Damages Business damages

recovery for lost profits are income (T had no basis in them, usually because costs were deducted)

recovery for harm to an asset is recovery of basis (taxable to the extent it exceeds basis; capital gains if the asset is capital, ordinary income otherwise) e.g. lost goodwill is return of capital

punitive, exemplary damages are income (T had no basis in them) no income if T can show that actual damages exceeded the settlement amount for prior undeducted losses (e.g. not enough income at the time), T can deduct lesser of

compensation received (minus legal expenses) or unrecovered losses sustained (§186) personal damages

physical injury/illness/emotional distress resulting from physical injury: excludable (§104(a)(2)) emotional distress/physical injury resulting from emotional distress: income loss of consortium: excludable lost wages: excludable punitive damages: income compensation for previously deducted medical expenses: taxable (tax benefit rule) damage to asset: excludable if payment is less than basis in asset (probably true because most are

not depreciable) interest portion of award: taxable

Tax-Exempt Interest Interest on state/local bonds is excluded (§103) Implicit tax: difference between the amount a municipality would have to charge if the interest were

taxable and the amount it does charge (e.g. for 35% taxpayer, 6.5% bond = 10% other investment, implicit tax is 35%) (rate of return on taxable investment – rate of return on tax-exempt bond)/rate of return on

taxable investment = implicit tax Inefficient: municipalities save 2/3 of what federal government loses (if municipality offers bond

at 8.5%, federal government loses $.35/dollar for 35% taxpayer and municipality makes only $.015/dollar) Where implicit tax = actual tax rate, municipality captures the value of the exemption Municipality must offer higher rate of return for a lower bracket, and then the highest bracket

gets a windfall and municipality only captures a portion of the benefit of the exemption Tax-preferred investments and transactions may bear implicit taxes (e.g. municipal bonds,

insurance contracts) §103(b)(2): income on municipal arbitrage bonds is taxable (before this, municipalities issued bonds

and used the proceeds to invest elsewhere [tax arbitrage]) Tax arbitrage: taking two offsetting financial positions that yield a positive after-tax return

because the tax code treats them differently

Deductions & Credits Above the line deductions: §62 (compute AGI)

Trade & business, trade/business for employees (reimbursed expenses, must be in connection with performance of services as employee), losses from sale/exchange of property (§161),

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expenses incurred for producing rents & royalties, retirement savings (§219), alimony (§215), moving expenses (§217), interest on education loans (§221), higher education expenses (§222), health savings accounts

Below the line deductions (itemized or standard): §63(c) (compute taxable income) Standard deduction OR Itemized deductions

Some limited to deductions from certain types of income, some subject to floor §67(a): miscellaneous itemized deductions can only be deducted to the extent they exceed

2% of AGI Anything other than interest (§163), taxes (§164), casualty/theft (§165), charitable

contributions and gifts (§170), medical expenses (§213), annuity payments cease before investment recovered (§72(b)(3)), amortizable bond premiums (§171), some others

Some disallowed for computing AMT Some deductions lost, some carry over Some credits are refundable, some carry over, some are lost §262: no deduction for personal expenses §263: no deduction for expenses to increase an estate (i.e. personal investment; but paying an

investment advisor is deductible under §212) Is expense deductible?: personal or to produce taxable income? If latter, is income current (income

this year and no income later) or capital (income in future years)? (if capital, expense is added to basis, not deducted) Trade/business or income-producing activity? (§162 vs. §212)

Ordinary & necessary expenses incurred in carrying on a trade or business (§162) Wages, insurance premiums on business assets, office rent, utilities, etc. (§162) §212: deduction for expenses from income-producing activities. Must produce taxable income, so

can’t deduct investment advisor fees for tax-exempt bonds (only applies to individuals, is below-the-line, and subject to 2% floor) (e.g. investing on the side) Definition of trade or business: T is involved in activity with continuity and regularity and has

primary purpose of earning income or profit Welch: paying creditors of bankrupt corporation to help develop T’s business is not ordinary.

Reputation is a capital asset. No deduction. §162 allows advertising cost deductions. This is between advertising and goodwill, which is

capital expense. §162: “all the ordinary and necessary expenses paid or incurred . . . in carrying on any trade or

business” ordinary in the type of business involved, even if it only happens once/lifetime necessary means helpful to T’s business, not essential Gillam: T’s legal fees after psychotic episode on plane on his way to a job were not normal,

usual, customary. The altercation and the legal fees did not further his trade as an artist. Legal expenses: look at origin of the claim (divorce settlement is personal, not business)

Trade/business/profit-seeking losses (§165) Reasonable compensation

Exacto Spring Corp.: CEO’s $1M salary was presumptively reasonable (salary approved by other owners and CEO’s work led to very high returns). “Independent investor” test: if an investor would be pleased with his returns and the returns are attributable to the officer, a higher salary is presumptively reasonable. BUT we also need to know risk to know if rate of return was reasonable

§162: “reasonable allowance for salaries or other compensation” Failure to pay dividends suggests salaries are unreasonable (not conclusive) Tax Court, 5th, 10th Cir.: multi-factor test (type/extent of services rendered, scarcity of

qualified employees, qualifications/prior earning capacity, contributions to the business, employer’s net earnings, prevailing compensation for employees with comparable jobs)

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Employer must also intend to compensate (can’t intend to avoid dividends) §162(m): CEO or four highest paid employees of publicly held corp. cannot deduct >$1M

unless compensation is performance-based Disguised salary: cannot move salary to lower-bracket person if he didn’t do the work. Will be

recharacterized as dividend to employee and income to other person (probably not gift because no donative intent)

Employee business expenses – when deductible to the employee, can be excluded as working condition fringe (wash) Amount of deduction:

1) ordinary & necessary in carrying on trade/business? 2) above the line or itemized? 3) if itemized, subject to 2% floor/2% haircut?

Deductible employee expenses: supplies, professional dues, journal subscriptions, cars for business calls Above the line: reimbursed expenses & some expenses of performing artists and Nat’l Guard,

expenses of self-employed independent contractors. Also employer trade/business expenses, losses from sale/exchange of property, contributions to qualified plans, alimony, moving expenses, interest on education loans

Below the line: unreimbursed expenses 2% floor: miscellaneous itemized deductions (§67) – unreimbursed employee expenses,

investment expenses (§212) Doesn’t apply to: interest, state/local taxes, charity, casualty/theft losses (has own

floor), medical expenses (has own floor) 2% haircut (§68) for high-income Ts (over $100k AGI adjusted for inflation, now

~$150k): all itemized deductions other than medical expenses, investment interest, gambling, casualty losses (haircut is being phased out) Reduction cannot be greater than 80% of the deductions. Same effect as raising top marginal tax rate Increases simplicity for Ts who cannot exceed floor §132(d) working condition fringe is payment to employee that would be deductible if

paid for by employee. Not subject to 2% floor. Haircut phased out: 1% in 2008-09, 0% in 2010

Personal business expenses Fine line between personal and business – most consumption contributes to income production Congress restricted certain deductions (e.g. home office, vacation homes, travel/entertainment) Various tests for deductibility (depends on the expense type):

Allowed when expense is appropriate and helpful to T’s business/income-producing activity Disallowed unless primary purpose was profit-seeking

Relaxed for public employees Expenditure must be “reasonable” Allowed to the extent of “additional expenses” due to business/income-producing needs Allocate expense between business and personal use Disallowed because “inherently personal”

Pevsner: YSL clothing not deductible because it was adaptable to general use as ordinary clothing (court rejected subjective test of what T would wear outside work; objective test more administrable) Test: deductible if 1) clothing is required for work, 2) it is not adaptable to general usage as

ordinary clothing, and 3) it is not so worn Courts suspicious of unreimbursed expenses because if employer found it helpful, he would

reimburse. If employee doesn’t pursue reimbursement to which he is entitled, he may lose the deduction.

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Tax credit for qualifying child care expenses (§21): 35% of expenses, phased to 20%. Credit limited to lower-income spouse’s income and expenses only qualify up to $3k for 1 kid/$6k for ≥2. Not refundable. Very few low-income Ts can take it and even fewer can take maximum credit ($2100).

Travel expenses Deductible when T traveling on business (§162(a)(2)) Commuting costs are nondeductible (personal) Meals/lodging while away from home in pursuit of trade/business

Must stay overnight (for business reasons) Even if overnight is for personal reasons, can still deduct airfare If companion flies free (and comes for personal reasons), T must prorate his fare deduction

Hantzis: law student who worked for summer in NYC while husband lived at home in Boston could not deduct the expenses of the transportation between NYC and Boston, the NYC apartment, and meals in NYC. If T maintains two homes for primarily personal reasons, no deduction allowed. Hantzis’s home was NYC. No business reason to maintain home in Boston.

Consumption element of business travel is ignored (if trip is primarily for business purposes) Limitations: meetings outside N. America unless location is reasonable in context

Temporary employment doctrine: temp job ≤ 1 yr, regular residence is “home” and food/lodging at temp job is deductible

Entertainment & business meals Moss: law firm partners who met every business day for lunch (firm paid, but firm is a

partnership) cannot deduct cost because daily meals are inherently personal. (Sutter: disallowed deductions for regular business meals). The firm did not need a daily lunch to derive income. Rationale for deduction: little consumption value to T. Moss partners enjoyed their lunch

and chose to do it, Sibla firemen were required to contribute to the meal fund so it’s deductible, Christey state troopers were required to eat at public rest stops on highways, so it’s deductible.

Client meal/entertainment is deductible if it is directly related or associated with active conduct of trade/business. T must have more than general expectation of deriving income, must discuss business before/during/after, and principal reason for expense must be trade/business. T’s meal is also deductible because he would not pay for it but for the business benefit, but must be reasonable amount.

§274(n): deduction limited to 50% of cost. If reimbursed, the 50% applies to reimbursing party, not T. T is not taxed on the amount. Reduction is because some portion of food/entertainment is definitely consumption

§274(d): substantiation with contemporaneous records required (business travel, meals, entertainment). Or T can take the regulation rate (varies by city).

Capitalized expenses §263: disallows deduction of capital expenditures (new buildings, permanent improvements to

increase value of any property or estate). Instead, added to T’s basis, and recovered on sale or through depreciation/amortization.

Some capital losses may be carried forward or back, but if not used in statutory period, they are lost. Purchasing/acquiring asset (stocks, land, contracts), constructing asset (building), raising capital

(issue debt), entering new trade/business: capitalized Expenditures producing income in later years, recurring expenses. Usually increases value of

identifiable asset (so it can be added to that asset’s basis). Exception: advertising costs, employee compensation Also, repairs produce future income but are deducted (vs. improvements)

Expenditures that produce capital gain/loss should be capitalized; those that produce ordinary income should be deducted (matching character).

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Woodward: must capitalize litigation expenses where origin of claim is in the process of acquiring an asset. Attorney, accountant, appraisal fees for Ts to purchase minority stock in a corporation were capital expenses. Also includes costs of equipment to build, taxes, salaries of construction workers

Intangibles INDOPCO: i-banking and legal fees incurred in friendly takeover are not ordinary, necessary

business expenses, so they must be capitalized (despite not being associated with a tangible asset)

Cost of purchasing/acquiring most intangibles (stock, leases, IP rights, licenses): capitalized. Amounts to create intangibles (obtain/modify contract rights, defend title): capitalized.

Exceptions: Employee salaries (but not independent contractor) Cost of borrowing to finance the acquisition overhead costs under $5k (e.g. employee flying to TX to buy asset) Maintaining existing asset: deductible (Staley: deduction of fees to fight hostile takeover) Contracts terminable at-will (e.g. signing bonus, franchises): deductible Wooing seller (payment in hopes of creating/acquiring asset): deductible Internal investigation of contract: deductible

Must involve “separate and distinct asset”: “a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable State, Federal or foreign law and the possession and control of which is intrinsically capable of being sold, transferred, or pledged . . . separate and apart from a trade or business.” Exceptions: package design, computer software developer fees, goodwill, consulting fees

Business expansion/reorganization: deductible (startup of new business: capitalized (§195)) Capitalized cost of intangible asset is amortized over useful life

T proves useful life for amortization, or use 15 yrs Repairs and improvements

Repairs (preserving asset, keeping in efficient operating condition): deductible (§§162, 212) Improvements (replacing property, permanent increase in value or prolonged life over original

expected life): capital (§263) Like buying a new asset Rev. Rul. 2001-4: doing routine maintenance on Aircraft 1 which did not prolong life or

increase value can be deducted; Aircraft 3 involved general plan of modernization/upgrade, so maintenance was part of that and all must be capitalized; Aircraft 2’s improvements must be capitalized, but the routine maintenance can be deducted because the main purpose of the work was maintenance (improvements were not part of original plan or impetus behind taking plane out of service)

Job-seeking and educational expenses Rev. Rul. 75-120: expenses of seeking employment in new trade/business not deductible;

expenses of seeking employment in existing trade/business deductible Test: separate trade/business if there are substantial differences between tasks and activities of

the occupations/employments Estate of Rockefeller: “holding public offices” is not a single trade/business

Educational expenses deductible if they bear a direct and proximate relation to T’s trade/business Wassenaar: T’s Tax LLM costs not deductible because he was not an attorney before getting

LLM (only on law review and summer employment, but not member of bar) Where self-improvement aspect is predominant over other goals, no deduction Travel as education: no deduction $5250 of employer-reimbursed undergrad/grad expenses are excludible (§127) General education deduction: $4000 for T/spouse/dependent’s college tuition/related

expenses. Used to be “cliffed” out by income level.12

Must be coordinated with other education benefits (Hope, Lifetime Learning, etc.) Option to expense

T has option to deduct expenses for: periodical circulation (§173), research/experiment (§174), farmer soil/water conservation (§175), environmental remediation (§198), qualified clean fuel vehicles (§179A), farmer fertilizer (§180), removing barriers to handicapped (§190) If no income that year, T would prefer capitalization

T has option to capitalize, e.g.: deductible interest, taxes, carrying charges (§266) Depreciation

Non-wasting assets: cost is part of basis, no depreciation, offset by reduction in sale price Wasting assets: Reasonable allowance for exhaustion, wear and tear (including a reasonable

allowance for obsolescence) of assets used in a trade or business or held for the production of income (§167)

allowance for allocable part of costs of business/investment assets depreciation allowance applied to basis (cost, capital expenditures added, etc., reduced by prior

depreciation deductions) ideal rate is economic depreciation (reflect actual loss in value). worse for T than straight-line.

E.g. bank account with declining balance earns more interest initially, so there is less depreciation initially.

rate of depreciation depends on depreciation method and recovery period straight line method: cost allocated equally over useful life declining balance method: constant percentage applied over useful life (so more depreciation

at the beginning, “accelerated depreciation”) double/200% declining balance method: percentage used is twice the percentage of

straight line method ($100 five-year asset would have 20% straight line, so 40% in first year = $40, 40% in second year = $24, etc.)

current rule: asset assigned to recovery class which determines recovery period (§168) 3, 5, 7, 10 yrs: 200% declining balance (switching to straight line when that gives larger

deduction) 15, 20 yrs: 150% declining balance (switching to straight line) Real estate: straight line Salvage value always excluded (since T will recover upon final disposition) Half-year depreciation in first and last years of ownership; half-month for real estate Intangibles (incl. goodwill) amortized on straight line basis over 15 years (§197) Commercial building: straight line over 39 years (§168) Small business preference: current deduction up to $100k of acquisition costs ≤$400k, with

dollar-for-dollar decrease after that. (§179) Annuity: straight line over life of annuity

T may elect to deduct some start-up ($5k for expenses up to $50k)/organizational expenses and amortize remainder over 15 yrs (§§195, 248) So starting new business for oneself allows some immediate deduction and shorter

amortization period than entering new profession as employee (amortization over lifetime, plus 2% floor/haircut)

Depreciation subject to later recapture if asset yields capital gain (recharacterized as income) No depreciation for personal property. If both personal and business, basis allocated. Land not depreciable; buildings are. If bought together, basis allocated. Antiques not depreciable (no determinable useful life)

Interest Deduction deductible if used for trade/business. Deductible without limit other than passive loss

exceptions: expensive long-lived asset T is constructing (§163). purchase/carry tax-exempt bond (§265(a)(2))

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expenses of producing tax-exempt income generally passive loss (trade/business in which the individual does not actively participate) only deductible

against passive income or when investment ends in loss (§469) if used for investment, deductible up to investment income (gross income – expenses), with

unlimited carryforward. (§163(d)) Investment income does not include net capital gains/dividends unless T forgoes preferential

rate. 163(d) prevents borrowing to buy investments and pay capital gains rate while deducting the

interest on the loan at the higher ordinary rate Generally nondeductible for personal uses (incl. life insurance, annuities)

Exceptions qualified residence interest. $1M to acquire, construct, substantially improve principal

residence or second home. $100K home equity. Debt must be secured by the residence. Below the line. (§264(h)(3))

Education loans: up to $2500 of interest paid. Above the line. Decreases with AGI. Must be T’s debt but can be for dependent’s education. (§221)

Accounts with mingled funds: withdrawal first of borrowed funds, then unborrowed. If more than one loan in account, FIFO.

Tax arbitrage: assets eligible for favored tax treatment are acquired with debt. Negative tax rate results when T gets interest deduction and zero rate of tax on income from the

asset purchased with the debt. Knetsch: T must pay interest on arbitrage scheme in which he bought ten 30-year annuities

($400k each, 2.5% interest) for $4,004,000; paid $4k and $4M nonrecourse notes with 3.5% interest; prepaid $140k interest. Kept borrowing on the annuity cash value, so payments limited to $1k. Deducted interest on the loans and deferred the income on the annuities and used the deduction to offset other income. Transaction did not appreciable affect his beneficial interest except to reduce his tax.

Economic substance doctrine: financial transactions will be recognized by court and give deductible interest only if there is a tax-independent purpose

Subjective rule: financial transaction not recognized unless it was done for a substantial business purpose

Sham transaction: one that never occurred Distinguishing interest from other payments

Interest is amount paid for the use or forbearance of money Halle: contract price for option to buy reset each day based on interest rate is an increase in

interest. On sales with deferred payments: if buyer is tax-indifferent and seller has high marginal rate,

they will prefer to characterize as much as possible as principal, on which seller pays capital gains rate and ordinary income on interest. If buyer has high rate and seller is tax-indifferent, they prefer to characterize more as interest because buyer can deduct it immediately against income.

Parties generally cannot recharacterize a transaction. Sometimes, but only if both parties agree. Losses

§165: deductions for losses incurred in trade/business or investment, not compensated by insurance Trade/business: net operating loss carryforward/back and above the line. Ordinary loss. Investment: above the line only if from sale/exchange of property or attributable to property that

produces rents/royalties. Otherwise below the line. Capital loss. Deductions for some personal casualty, theft losses. Otherwise no personal loss deductions.

Ordinary, and only above 10% of AGI Carryforward/back Gambling losses deductible to the extent of gambling gains.

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If used for different purposes, allocate losses. Limitations on deductions:

Losses that might be personal Losses related to unrealized gains Tax shelter losses

Objective test of loss (actually lost value, not T thought it did). Timing: identifiable event indicating no reasonable prospect of recovery.

Amount: adjusted basis of the property – any insurance payment Hobby losses: not-for-profit activities (§183)

Plunkett: T’s mud racing was not-for-profit so he couldn’t deduct losses. His truck pulling was for-profit, so he could deduct losses up to the amount of related income. Test: did the individual engage in the activity with the actual and honest objective of making

a profit? Look at: manner activity is carried on, T’s expertise, time/effort spent, expectation that assets involved will appreciate, T’s success in other similar or dissimilar activities, T’s history of income/loss on the activity, amount of occasional profits earned, T’s financial status, personal pleasure/recreation involved

Rebuttable presumption: requisite profit motive if profits produced in 3 of the past 5 years. If this isn’t met, T can use Plunkett factors.

Hobby losses are miscellaneous deductible (2%/2%) Losses incurred in a trade or business always are deductible above the line. Losses incurred in other

profit seeking activity sometimes are deducted below the line and if so are subject to the floor and the haircut.

Loss road map - A loss may result from a disposition of property at a loss (i.e., for an amount less than basis), a casualty to property, or when expenses of an activity exceed income from the activity. Personal losses (i.e., losses not incurred in a profit-seeking activity) are deductible only if they

are casualty/theft losses and only to the extent they exceed 10% of AGI. § 165(c)(3). Casualty losses are ordinary, not capital. They may be carried forward or back under § 172. [See 172(d)(4)(C).] They are not treated as miscellaneous itemized deductions subject to the 2% floor, § 67(b)(3), or the “haircut” in § 68.

Losses in a profit-seeking activity that is not a trade or business. If the loss is on sale or exchange of property, it probably is a capital loss subject to the capital

loss limitation. The loss is above the line. See § 62(a)(3). If it is a deduction attributable to rents and royalties it is above the line (§ 62(a)(4)) but

cannot be carried forward or back under § 172. If it is a casualty loss, then it is fully deductible under § 165(d), it is not subject to the 2%

floor or the haircut in § 68, and it may be carried forward and back. Other losses are below the line and subject to the 2% floor and the “haircut” in § 68, cannot

be carried forward or back under § 172, and are not deductible in determining the alternative minimum tax, § 56(b)(1)(A)(i).

Losses in a profit-seeking activity that is a trade or business. If the loss is on sale of exchange of property, it may well be ordinary under § 1031. Deductions are above the line and losses may be carried forward and back. Casualty loss: deduction is basis (not FMV, because no attribution to consumption)

Non-casualty loss must be realized, so damage to asset does not result in loss until sale/disposition of the asset.

Trade/business: T must be actively engaged, must be continuous and regular activity. Casualty losses: 165(c)(3)

Deduction for personal loss from “fire, storm, shipwreck, or other casualty, or from theft” Must exceed $100 and 10% of AGI. No deduction if received insurance payments or any

prospect of recovery, and must filed timely insurance claim. Itemized

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Rationale: no ability to pay tax when T has these losses and not result of personal consumption choice

Critique: deduction decreases incentive to get insurance Casualty: Sudden, unexpected, violent, not due to deliberate or willful actions. Advance warning

precludes deduction. Can result from T’s negligence, but not gross negligence or more. Theft: must prove defrauding or stealing. Cannot be T’s accident. Loss = lesser of adjusted basis or (FMV before casualty – FMV after casualty) §123: reimbursement for living expenses when home destroyed are excluded from income

Limitations on losses Fender: T could not deduct losses from selling and repurchasing bonds to a bank in which he

was a majority shareholder because there was no reason to sell the bonds other than to avoid tax. T was not exposed to any risk that he wouldn’t be able to repurchase the bonds, and it would be difficult to find buyer other than the bank.

No deduction for sale/exchange of property between related people (§267). Loss is lost unless buyer sells at a gain, then he can include the disallowed loss in his basis.

Wash sales: no deduction for losses from sale and purchase of same securities within 30 days (but the loss is added to his basis, so it is deferred until a real sale) (§1091)

Capital losses: deductible only to the extent of capital gains plus $3k ordinary income (§1211). Indefinite carryforward (§1212)

Straddles: T retains related assets with unrealized gains and uses tax losses to get optimum tax treatment regardless of overall economic position. E.g. offsetting positions in commodity futures contracts. Sell loss portion and retain gain portion so loss is accelerated and offsetting gain is deferred. §1092: deduction of straddle losses limited to amount by which losses exceed unrecognized

gains on the offsetting position Some stock and options get mark-to-market treatment (as if all are sold at year end, so only

losses that exceed matching gains can be taken) Real estate tax shelters

Often structured as limited partnerships, include investment/transaction that produces tax savings greater than that which would be appropriate given its economic income or loss.

Legitimate tax shelters: tax-favored investments sanctioned by tax laws to create incentives for certain activities

Abusive tax shelters: transactions that would not stand in court Techniques:

Income shifting: move income/deductions/credits among taxpayers (e.g. Estate of Franklin sale-leaseback)

Exemption: economic income not subject to tax (e.g. IRAs, municipal bonds) Deferral: accelerate deductions/credits, postpone income. Early deduction usually offsets

unrelated income. Conversion: investment generates deductions against ordinary income and income taxed at

favorable rates (usually capital rate) Leverage: use borrowed funds to increase deductible expenditures. Greatest advantage in

nonrecourse debt. Frank Lyon Co.: tax shelter of sale-leaseback of building being constructed by company (T took

out loan and company’s rent equaled it) was legitimate because regulations required company to have third-party owner, T bore risks of company defaulting, because the loan was recourse, and company exercising repurchase option or not renewing if interest rate changed enough, there was competitive bidding for the contract, there was no net tax benefit, and more than two parties were involved (more likely to be arm’s length, not like Franklin)

§465: losses financed by nonrecourse borrowing can only be deducted against income from the same activity

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Bad Debts Bad business debt: ordinary loss, and can deduct only a worthless portion Nonbusiness bad debt: short-term capital loss, and must be completely worthless Generes: T could not take bad deduction for unrepaid $300k loan to a corporation in which he had

invested $39k and received annual salary of $12k because his dominant motivation was to protect his investment, not his salary. If lending activities are extensive and continuous, may be considered T’s business

No deduction if debt was worthless when acquired Loss from guaranteeing loan = as if loan were made directly (same loss) No deduction for bad debts owed by political party No deduction if debt was voluntarily canceled by T, unless cancellation was for business purpose.

Personal deductions & credits Standard deduction: taken instead of itemizing ($6k joint, $3k single, $4400 HH; 2007: $10,700,

$5350, $7850). Marriage bonus for couple with one wage earner. For individual who can be claimed as a dependent: lesser of $3k or greater of $500 or T’s

earnings + $250 Some Ts must itemize: married filing separately if other spouse itemizes, nonresident aliens,

citizens with income from U.S. possessions, estates, trusts, common trust funds, partnerships Rationale: simplification, or adjust tax rate schedules so very low-income Ts not taxed Problem: no incentive power of itemized deductions for nonitemizers Head of household: unmarried and maintains household which is principal residence >1/2 year

for qualifying child/dependent or maintains separate household for dependent parent Personal exemption

$2,000 (§151) indexed for inflation ($3,400 for 2007) Exemption for both spouses, each dependent (§152)

Qualifying child: lineal descendant/sibling/lineal descendant of sibling, same principal place of abode >1/2 yr, under 19/24 if student, did not provide >1/2 own support

Custodial parent gets exemption unless they agree otherwise Qualifying relative: relative of anyone in T’s principal place of abode; gross income <$3050,

T provides >1/2 support, not qualifying child, relationship doesn’t violate state law T cannot claim if another can claim T as dependent Phased out by income (over ~$200k)

Dependent child credit (§24) $1,000 for each qualifying child under 17, phased out by income. Refundable up to a portion of

T’s earned income. ([15% x earned income] - $10k adjusted for inflation) Rationale: set some amount that should not be taxed (then there should be no phaseout) or

exempt subsistence level of income from taxation Earned income credit (§32)

Eligible Ts: Ts with qualifying child, individuals 25-65 who are not another’s dependent Marriage penalty (lower percentage refunded for married couples than two individuals) Refundable

Elderly/disabled: credit of 15% of income, with specified maximum (§22(a)), reduced by SS and RR benefits and other tax-exempt retirement income

Education credits Nonrefundable Phased out by income (except §529), aimed at middle-income Ts Hope Credit: up to $1500 for first 2 yrs of college for T/spouse/dependent (§25A(b)) Lifetime Learning Credit: undergrad/grad education, 20% of tuition/fees up to $10k, (§25A(c)) If T takes Hope/Lifetime for student, no one else can take deduction for that student Coverdell Education Savings Account: up to $2k/yr, distributions for

elementary/secondary/higher education for T/spouse/dependent. Phased out at ~$200k AGI.17

§529 Plans run by states, some colleges: no phaseout, so good for high-income Ts. Personal itemized deductions

State, local, foreign taxes (§164). Property taxes must be based on property’s value and imposed on annual basis Must be

personal property Income: largest deduction for most itemizers (Ts in states w/o income tax may deduct state or

local sales tax instead) Foreign income taxes: credit against income

Charitable contributions Cash, FMV of property, but not services (§170)

Expenses incurred in donating are deductible (e.g. food, lodging, paying someone to help) Limited to 50% of AGI (corporations: 10% of taxable income); appreciated property limited to

30% AGI Haircut, not floor Hernandez: contributions to Church of Scientology were not deductible because they were

payments for church services (audits and training). Charitable contribution must not involve quid pro quo Dissent: IRS allows deductions for quid pro quos in other religions (e.g. pew fees, dues) 1993: donations allowed for “intangible religious benefits” without commercial value outside

the donative context Substantiation requirement: charity must give receipt noting if anything was provided that has a

non-donative market value (e.g. book for radio donation), and gift of property over $5k requires qualified appraisal. Car/boat/plane: deduction limited to resale price if charity resells.

Courts increasingly follow Duberstein test (detached, disinterested generosity) But many charitable gifts are made with sense of moral obligation

Transamerica: no deduction where there is direct economic benefit, but deduction where there is indirect business benefit like public recognition of charitable giving

If donation makes donor eligible for athletic tickets, donation limited to 80% No deduction if payment is in lieu of a service (e.g. tuition) Property: T can deduct FMV of property regardless of embedded appreciation (no gain realized)

Exception: property that would produce ordinary income or short-term capital gain if sold, or any property donated to private foundation (except qualified stock), or any tangible personal property unrelated to charity’s function - deduction is reduced by amount of unrealized gain. (§170(e))

Depreciated property: should sell first, realize the loss, then donate. Charity: public activities, religious, scientific, literary, educational, preventing cruelty to animals

or children. Cannot be involved in propaganda/political campaigns/activities against public policy.

Alternative Minimum Tax (AMT) (§55(a)) Rationale: Ts shouldn’t be able to get out of paying all tax when they are able to pay; broadens tax

base AMT applies if it produces greater tax than regular tax would. Growing number of Ts will be subject because AMT exemption is not indexed for inflation and it

includes middle-class-oriented deductions and credits (state income taxes, personal credits, etc.) 26% of first $175k of AMT base, 28% on the rest

AMT base: AMT income – allowable exemption ($45k married/$33,750 single, reduced 25 cents/dollar over ~$150k married/$112,500 single)

Base up to $62,550 (0%), up to $237,550 (26%), higher (28%) (a little higher because of $.25/$1 phaseout after $150k)

AMT income: slower depreciation rates, disallowing some itemized deductions (p. 774-76)

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No standard deduction, personal exemptions, no deduction for state/local taxes, only interest on 1 home mortgage, ISOs, etc.

Not simple, may restore tax equity and increase compliance because people will perceive the system as fair, can recapture windfalls (like tax-exempt bonds for high-income Ts)

Congress must extend $62,500 base amount in 2008 or the AMT will apply after $45k. Standard, personal deductions are indexed for inflation and AMT is not. More people subject to AMT.

Financial planning is difficult if T doesn’t know if he’ll be subject to AMT Whose Income Is It?

Taxation of the Family and on divorce Poe: income split between spouses in community property states. Huge benefit for couples in those

states, especially when rates were very progressive. 1948: Congress created joint return. 1969: reduced rates for singles.

Druker: marriage penalty is not unconstitutional. It is impossible to design a progressive tax rate schedule that involves no marriage penalty, no singles penalty, and horizontal equity. Second earner’s salary taxed at higher marginal rate after marriage. Standard deduction for

married is < twice single. Also penalty in EIC (p. 420), haircut (because phaseout begins at the same income level regardless of status), phaseout of dependent exemption.

Marriage bonus: if one spouse earns >> other spouse, their combined taxes decrease due to lower rate on larger earner’s income.

Imputed income problem: since income from domestic services not imputed, this creates incentive not to work unless T can earn more than a certain amount after taxes.

Kiddie tax (§1(g)) restrict intrafamily income shifting Children under 19 and students under 24 $1k indexed for inflation ($1400) of child’s unearned income is not subject to kiddie tax (uses

child’s, not parent’s rate) Up to $700, no tax; $700-1400 gets kid’s rate (10%), above $1400 gets parent’s marginal rate

Spouses jointly, severally liable for tax liability on joint return. But if tax understated, if one spouse didn’t know the mistakes, he is not liable for penalty/assessment.

Civil unions/domestic partners must file separately. Head of household: one spouse living apart/ex can use this, other must file as single (§7703(b)); T

married to nonresident alien uses this also Divorce

Rev. Rul. 76-255 Determination of marriage status as of close of taxable year IRS doesn’t question validity of divorce decree until court w/jurisdiction declares it invalid If no valid marriage ever existed, couple could not file jointly Divorce has no effect for tax purposes if it is only to avoid taxes (couple intends to remarry at

time of divorce) Alimony/support

Taxable to one of the spouses Alimony: recipient taxed, payor gets deduction (§71). Parties can elect not to do this.

Above the line Cannot have any obligation to pay after spouse’s death, cannot be reduced upon child-

related events, e.g. graduation (this is child support) Cannot be front-end loaded (this is property settlement) (§71(f)). Declining payment is

okay as long as decline is <$15k/yr. Excess payments recaptured in year 3 Yr 2 excess = yr3 + $15k – yr2 Yr 1 excess = yr1 - [([yr2 – yr2excess] + yr3)/2] + $15k

Child support/property settlements: recipient excludes, payor cannot deduct (§152) Rationale: payor gets consumption value of paying for his child

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Property settlements: no gain/loss recognized on transfer incident to divorce. Recipient takes adjusted basis of transferor (so transferee is eventually taxed). (Treated like gift.) (§1041) Must be related to the divorce (in divorce document and within 6 yrs) or within one year Davis: H recognizes gain when he gives W stock to satisfy marital obligations (marital

obligation cannot be valued, but assumed it is equal to what is given up). W takes FMV basis. §1041 reversed this.

Theory: family is taxable unit, so tax should only be imposed once; or transfer is in lieu of support that would have been untaxed

Requires divorce/separation agreement (cannot just be offer to pay) Delinquent payments applied against child support first, then alimony

Antenuptial agreements Farid-Es-Sultaneh: wife gave up valuable legal right (marital rights) upon receipt of husband’s

stock, so it was not a gift. She takes basis on day of transfer, not husband’s (much lower) basis. Dissent: the pre-marriage gift of 700 shares could not have been a sale because she didn’t

have marital rights at that point. No double taxation within family unit. So if there is an exchange/transfer, no realization, only one

side is taxed. Assignment of Income

Earned income taxable to earner; income from property taxable to owner Earl: H must pay tax on income he earned even if he assigned it in advance to his wife and therefore

never had legal ownership of it. Today this result can be achieved through joint returns Same applies to, e.g., employer putting some of employee’s salary in trust for kid’s education

Hundley: T had to pay income on salary assigned to father as his baseball agent, but could take business deduction for the salary paid.

Rev. Rul. 74-581: where amounts received by law professors for pro bono work were endorsed to their law school, the income was excludible to them because the pro bono work was part of their duties as professors. If they had been included, professors would get business expense deduction when turning over to

the law school, but employee business deductions are subject to 2% floor. Less favorable. Agency theory of assignment: Employee performs services, paid directly, gives funds to employer,

employee is not taxed because he is employer’s agent. Priest not taxed on income turned over to church if the church itself performs those services.

Otherwise, priest gets charity deduction (e.g. ascetics who give their outside income to the church).

Giannini: employee who refused income and the corporation created a university foundation named for him did not have to include it as income.

Income from property: If property gifted, any income from it is taxable to donee If income from property gifted, donor is responsible for tax Blair: T’s children responsible for tax on income from trust he had assigned to them. Horst: T owed tax on interest earned on bonds when he had detached the interest coupons just

before maturity and given them as a gift to his son. He got the benefit of giving his son a gift. Overruled by §1286: basis of bond is allocated between portion retained and portion

transferred. Both parties subject to OID rules (each party reports increase in value of his part each year). Total amount of income is the same.

But generally, deferred compensation is taxable to the earner, not the donee. Heim: where T assigned 25% of an agreement to receive royalties from patents (that included

reversionary interest and ability to negotiate other royalties on new products), the assignees (wife, kids) were taxable, not T.

Short-term temporal carve-outs are ineffective to assign income.20

To avoid problems, people should make property gifts, not contract gifts (e.g. copyright itself, not right to royalties).

Capital Gains & Losses Rates:

5% for long-term if T in 10/15% bracket 10% for T in 10% bracket, on short-term gains, gain to the extent of depreciation on long-term real

estate, collectibles 15% for T in 15% bracket, on short-term, gain to extent of depreciation on long-term real estate,

collectibles 15% normal long-term rate 25% for 25% or over T, gain to extent of depreciation on long-term real estate 25% for 25% T, gain on collectibles 28% for 28% or over T, gain on collectibles

Mechanics Realization requirement Capital losses only deductible against capital gains (plus $3k income for individuals) Holding period: 12 months. Long-term > 1 year. For carryover and substituted basis (gifts, like-

kind exchange?), donor’s time is tacked onto donee’s. Calculating capital gains:

[Short-term gains – short-term losses] - [long-term gains – long-term losses]. Net short-term gain = ordinary income Net long-term gain = capital gains If there is net gain on both, tax each on its own rate Net loss = offset $3k ordinary income (short-term is used up first), excess carried forward (and

each type of loss retains its character) E.g. $4k long-term loss, $2k short-term loss. $3k offsets T’s ordinary income, $3k long-term

loss is carried forward (first $3k was $2k short, $1k long). Corporations: no preferential capital gains rate. No offsetting ordinary income. Carry forward 5

yrs, carry back 3 yrs. Policy

Arguments for preferential treatment: Capital gains are not income (not recurring, sometimes just reflect changes in interest rates

Dollar of capital gain gives just as much ability to pay as dollar of income. Equity demands no preference. Dollar of capital gain is different for all the reasons below (different savings pattern,

bunching, etc.) Bunching: realization forces tax all in the year of disposition, but gains accrued over years.

Bunching may force T into higher marginal tax bracket. But T got benefit of tax deferral

Capital gain may just be inflation May be offset by benefit of tax deferral. Capital gains rate bears no relation to inflation rate.

Tax on stock is double taxation Problem is with corporate taxation, not capital gains. Appropriate solution would be to

coordinate stockholder and corporation’s tax. Disincentive to risk-taking: tax reduces expected return.

Complete tax offset for losses would help. Government bears some of the risk of loss. Disincentive to savings: the earnings would tend to be saved by individuals, not spent.

Government spends immediately. When T is taxed, savings suffer before consumption. Solution is taxing consumption, not income.

Lock-in: Ts don’t sell to avoid taxes21

Mark-to-market would solve this. Arguments against preferential treatment:

Complexity. This is not solved by taxing at ordinary income rates. Complexity comes from measuring

gain/loss, not from applying the favorable rate. Primarily benefits high-income Ts, produces too little additional risk taking and saving to

compensate for the lost revenue If rate were higher, people would defer realization, leading to less revenue. Wealthy can

always control timing of tax because they can borrow against appreciated assets instead of liquidating.

Definition Capital transaction: 1) involves property that is a capital asset; 2) property is transferred in

sale/exchange; 3) minimum holding period must be met Capital: investment, reward for taking risk, market fluctuation; ordinary: compensation for services,

interest from passage of time, normal business profit (wages, interest, rent; payment for use of person’s services, money, property)

Most property is a capital asset. §1221 exceptions:

Stock in trade or inventory of a business, or property held primarily for sale to customers in the ordinary course of trade/business

Depreciable or real property used in trade/business Literary/artistic property held by its creator

Composers can elect for capital treatment Accounts or notes receivable acquired in the ordinary course of trade/business U.S. gov’t publications sold at below-public price Commodities derivative financial instruments held by commodities derivative dealers Identified hedging transactions Supplies regularly consumed in ordinary course of trade/business

Statutory Framework Property held for sale to customers (§1221(a)(1))

Malat: “primarily” means “of first importance” so district/tax court must determine this. Timing problem: at time of sale, T’s purpose is certainly to sell (tautology)

Equipment sold after rent-producing potential ended can get capital treatment Bramblett: T can apply capital rate to gains from sale of property to related entity that then

developed it and sold in several parcels. T did not sell frequently, held the property 3 years, did not advertise, did not have office. Town East was not Mesquite East’s agent. Court looked at: is T engaged in t/b, if so, what? Was property primarily held for sale in

that t/b? were sales “ordinary” in the course of t/b? nature/purpose of acquisition, duration of ownership, T’s efforts to sell, substantiality of sales, subdivision/development/advertising, use of business office to sell property, control by T over representative seller, time and effort devoted to sales.

If T subdivided to facilitate liquidation, that helps his case for capital treatment. Continental Can: antitrust law forced T to sell previously leased sealing equipment to can

customers. Held: ordinary gain, there was no change in T’s intent (forced to sell). Stocks/securities

Dealer: realizes profit through mark-up, not through rise in value of stock (ordinary income)

Trader: in t/b (ordinary income) if trading is frequent, substantial (although profit is from rise in value)

Investor: profit from rise in value, but usually disregards short-term profit. Always capital.

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Property used in business §1231: real/depreciable property used in t/b yields capital gains and ordinary loss.

Includes gains/losses on insurance, casualty, involuntary conversion Calculation:

Firepot: (gains from casualty/theft loss (insurance) – casualty/theft loss) net losses §1231 does not apply, gains are added to income, losses are

deductible from ordinary income net gains use firepot in hodgepot comparison

hodgepot: compare gains from firepot (if applicable) – [gains from condemnation/sale – losses from condemnation/sale) net losses gains are ordinary income, losses are deductible from ordinary

income net gains gains are long-term capital, losses are long-term capital

if T has §1231 loss followed by §1231 gain in the next five years, the loss is recaptured by treating that portion of the gain as ordinary income

§1245 recapture of previously deducted depreciation (T still gets time value) Up to amount of depreciation, gain is taxed as ordinary. E.g. $100k property, T takes

$40k depreciation deductions. T later sells for $150k. $10k capital gains, $40k ordinary. Similar provisions for soil/water conservation, drilling/mining costs, oil/gas depletion. Does not apply to real property (§1250 applies: accelerated depreciation is recaptured) Gain up to amount of depreciation on real property held >12 months taxed at 25%

Self-created intangibles Copyrights, literary/musical/artistic compositions, letters/memos/similar property prepared

for T are not capital asset in creator’s hands or when basis is determined by creator’s basis (§§1221(a)(3), 1231(b)(1)(C)) If children inherit copyright, they get basis step-up and any gains are capital. If creator

gifts copyright to children, their basis is his and their gains are ordinary. §1235: capital gains for sale of patent by inventor, but must transfer all substantial rights §1223(b)(3): music composer can opt for capital gain/loss treatment (can get the best of both

worlds, like §1231: ordinary loss, capital gain) “similar property” – software creator has ordinary income on sale of program

Exception: records that are part of going concern value (e.g. patient records). Capital. §1221(a)(3) does not cover trade secrets, trade names. Capital assets.

Financial contracts used in business §1221(a)(4): accounts or notes receivable acquired in the ordinary course of trade or business

for services rendered or from the sale of property held for sale to customers in the ordinary course of business

§1221(a)(5): government publications received by Ts without charge or at reduced price Ts should not get deductions for FMV of the materials when they’re contributed to

charity (library/university) §1221(a)(7) and (8): hedging transactions, derivatives, supplies used in business

Corn Prods.: T realized ordinary income on sale of corn futures because it bought them to hedge against rising corn prices. Its business was corn, so the hedging was part of its t/b. IRS won the battle, lost the war because Ts will argue that losing investments were

held for t/b purposes. Arkansas Best: T’s loss on sale of stock in a failing bank was capital because §1221 at

that time defined capital asset as “property held by a taxpayer (whether or not connected with his business)” and didn’t fall into any of the exceptions (T didn’t argue it was inventory).

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If it doesn’t fit into a 1221(a) category, it is capital. Seems like it overturns Corn Prods., but basically that case was just an expansive reading of 1221(a)(1)

Hedge must be on ordinary property. If hedge is to protect investment, gain/loss is capital.

T must declare something a hedge immediately to prevent calling it not a hedge later if it is profitable.

§1256: some financial contracts and options must be marked to market each year, including business hedges that are not considered ordinary. Gain/loss is 40% short-term, 60% long.

Small business stock gets preferential rate (§1202) (exclude 50% of stock acquired at original issuance and sold >5 yrs later, remainder taxed at preferential rates depending on T’s income) Small business = net worth <$50M, ≥80% assets used in conduct of active t/b during T’s

holding period, primary asset is not reputation of its employees (law, accounting, athletics, etc.)

Dividends will be treated as ordinary income in 2010. Common Law of Capital Gains

No capital treatment where substitute for future ordinary income Carve-outs

Vertical carve-out (interest coterminous with seller’s rights): capital (selling the tree) Horizontal carve-out (interest sold ends before seller’s rights): ordinary (selling fruit) Hort: prepayment of lease (to get out of contract) was ordinary income to landlord. P.G. Lake: president’s cancellation of debt in exchange for an assignment of oil payment

rights was a lump sum substitute for what would be future ordinary income on the oil. It was not a sale producing capital assets. Sale of interest income (without sale of underlying asset) produces ordinary income

Bell’s Estate: assignment of life trusts to the remainderman resulted in capital gains to T. T sold the asset itself, not just the right to future income.

§1258: gain realized on conversion transaction is ordinary. E.g. T buys $62 gold, enters forward contract to sell it in 5 yrs for $100. Correct to call it ordinary because T is only getting the time value of his money (interest), but incorrect to tax all at the back end (gives preference over other investments yielding ordinary income, like OID).

Usually no basis allocated to the carved out interest (Hort) but it must be allocated when the carveout is given as gift/devise/etc. because otherwise family could carve up interest, hold gain portion (carved out interest) and take a loss on the asset (since whole basis is allocated to asset, despite it losing value due to carveout). §1001(e): where basis is determined under §§1014 (gift), 1015 (bequest), 1041 (property

transfer incident to divorce), basis is allocated to the carved out portion, but disregarded §1001(e)(3): unless the asset and interest are sold to the same person (because no risk of

holding on to gain only) §167(e): holder of carved out interest cannot deduct depreciation/amortization when

remainder is held by a related person (although the interest itself is wasting), but disallowed depreciation shifts to holder of the asset/remainder. This is because the reduction in the value of the interest is tied to an increase in value of

the remainder. What is property

Ferrer: T, actor, had a lease on the play Moulin Rouge, the right to block sale of movie rights if he produced the play and to 40% proceeds from the movie. He sells both rights to Moulin as part of deal to act in movie. Moulin paid him salary and some profits, contingent on his performance. Surrender of lease on play is like lessee’s surrender of lease (Hort) but Ferrer could get injunction to enforce lease, so it is like property. Same re: right to block movie.

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Capital gain for those two. But 40% proceeds is a right to future income, so selling that right now produces ordinary income. Property: injunction, enforceable against world - capital Contract: damages, enforceable against other contractors - ordinary

Maginnis: proceeds from sale of lottery ticket were ordinary because T made no investment, sale did not represent an accretion of value over cost. Not true: payment for ticket is very small investment and winnings are huge accretion

Lattera: Lottery winner who sold right to remaining future payments had ordinary income. 1) family resemblance test: does it look more like stock/bond or interest/rent?

2) type of carve-out: horizontal (ordinary), vertical (capital) 3) character of the asset: right to earn income (capital), right to earned income

(ordinary) when T receives payment both for services rendered and an asset, the price must be allocated.

Ferrer was remanded for tax court to determine this wrt the 40% proceeds. Property is a capital asset, unless one of the §1221 exceptions apply, or unless it is a

claim/right to ordinary income Sale of a going business

Williams: upon sale of going business, look at each part separately to determine characterization. In sale of hardware store, fixtures, inventory, goodwill, and receivables were all capital and everything else was ordinary. Typical problem: how much of business is goodwill (capital, 15-yr straight-line

depreciation) Prior transactions

Cummings: since gains on illegal 16(b) sale/repurchase were capital, T’s repayment of the gains was a capital loss (despite being done for a business purpose, i.e. preserving business reputation). Dissent: T should have to add the repayment to MGM to his purchase price because the

disgorgement was caused by the repurchase, not the sale. (Worse for T, because his capital loss is deferred to a later date, when he sells.) §1212(b): T cannot carry the loss back to 1961 to offset the capital gains he reported

then. Arrowsmith doctrine: transactions that are sufficiently related to an earlier transaction that

produced capital gains must be treated as producing capital loss. Sometimes applied to reverse: gain related to earlier loss reported as capital must be

reported as capital also. Ordinary income linked to later deduction, deduction usually treated as ordinary Where an ordinary deduction is linked to later gain, the gain is not always treated as

ordinary income What is a sale or exchange

Short sale: contract for sale of shares which seller does not own, but will make available for delivery at the time when delivery must be made

Prior law: no recognition on the short sale because cost of securities not known. Recognition postponed until T returned identical property to the lender.

§1259: tax to holder on any gain where there is a constructive sale of an appreciated financial position. Constructive sale: T/related person enters short sale or offsetting notional principal contract with

respect to substantially identical property. Also when T holds appreciated short position and acquires long position in same property.

At time of sale, seller recognizes the difference between the FMV and his basis, then when the contract is closed, the remainder of the gain is recognized.

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Yarbro: T had capital loss when he abandoned property subject to a mortgage whose value exceeded the property value. The abandonment was a sale/exchange because T exchanged his property for a relief from his debt. The relief from debt caused T to abandon. Where T receives some benefit by abandoning (e.g. release of a legal obligation), the loss must

be capital. Otherwise T with very low worth property will abandon rather than sell, to get ordinary loss instead of capital loss.

Sale/extinguishment of contract rights (e.g. tenure, lease provision calling for return of property in same condition) is not a sale/exchange. The right cannot be transferred to or utilized by another. So T realizes ordinary income, not capital gains.

Structure sale as lease to convert ordinary income into capital gains. E.g. Corp sells stock to Charity, which pays nothing. Charity liquidates stock, leases assets back to NewCorp, which pays its profits to Charity as rental payments. Charity pays it back to NewCorp as installment payments on the purchase price of the stock.

§514: tax on income of tax-exempt organization from debt-financed property. Net income taxable in proportion to ratio of debt to adjusted basis of the property. Approach can still be used with a company that has net operating losses.

§1231: how to characterize losses on involuntary conversions of business assets Stocks/bonds that become worthless: capital loss (§165(a), (c)(2))

Or ordinary loss if it is qualifying small business stock Nonbusiness bad debt: short-term capital loss (§166(d))

Bad business debt: ordinary, other than securities (§166(e)) Casualty losses: business run through §1231; personal is capital loss (§165(h))

Rationale: nonbusiness bad debt and personal casualty losses were not profit-seeking anyway, so shouldn’t get ordinary loss.

Payment by company to retire stock: capital gain (§331) §1241: amount received by lessee/distributor (not supplier) for cancellation of lease/distributor

agmt is capital gain/loss Net gifts

Diedrich: where T makes gift of property on condition that the donee pay the gift tax, T has income of donor’s adjusted basis – gift tax paid. Donor has the debt to IRS, and he has been relieved of that. Estate of Weeden: donor realizes income in the year that donee pays the gift tax (if cash basis

T) Tax liability < transferor’s basis no gain, and transferee gets transferor’s basis Tax liability > transferor’s basis transferor has gain on (liability – basis) and transferee

gets basis in the tax liability paid For part-gift/part-sale to charity, transferor’s basis is apportioned and he can deduct (gift

portion – basis apportioned to part). Holding period

Year + 1 day. Day of purchase is excluded, day of sale is included No holding period requirement for capital assets acquired through inheritance (§1223(11)) Holding period of previous owner is tacked on for, e.g., gifts (§1223)

Nonrecognition rules Recognition postponed until T’s investment is significantly altered Like-kind exchanges

No recognition when certain property held for productive use in t/b or for investment is exchanged for property of a like kind (§1031)

Basis of property given up becomes basis of property received (§1031(d)) Gain realized is recognized up to the amount of any boot received

T recognizes gain, but not loss, on any boot received (§1031(b), (c))26

BOOT: non-qualifying consideration (cash, stock, assumption of liability) Transferor (of boot) recognizes gain up to the amount of boot received (first taxed on the

gain, then it reduces basis) Transferee (of boot) increases basis by the amount of boot paid

Basis = original basis – boot received (or + boot paid) + gain recognized Debt

Assumption of debt by a transferee is treated as cash paid to transferor on relief of debt If both parties swap debt, the debt is netted and the one with more relieved debt is treated

as having that amount of cash as boot Transaction in which T receives cash which he uses to buy like-kind property will be treated as a

sale, not like-kind exchange To avoid, T must designate the property within 45 days and complete the exchange within

180 days Both properties must be held for t/b or investment if T has intent to give the property received as a gift (not hold for investment), it is a sale §1031 is mandatory, not elective. If T wants to realize loss on property before exchanging, he

should sell first, then buy the other property. Like-kind property: within the same class (10 classes)

Intangibles, nondepreciable property not in the classes; regulations consider these “like kind” defined more narrowly for personal property than real property

§1031 limited where exchange is between related parties: If either party disposes within 2 yrs, the gain on the original transfer is recognized on

disposition Holding period of previously held property tacked on to holding period of acquired property

(§1223(1)) if basis in the two properties is equal and property given up was capital asset or a §1231 asset at the time of exchange

Rationale: avoid taxing when T has no liquidity to pay the tax; also difficult to value the property; T has changed only substance, not form of investment

Involuntary conversions

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§1033: nonrecognition is permitted on gain resulting from involuntary conversions if T uses proceeds to acquire property of similar use (or, if real estate, like kind) within 2 yrs after involuntary conversion

Elective, not mandatory No nonrecognition treatment for stock in trade or property held primarily for sale (§1033(g)).

Where disposition was a matter of business discretion, not practical necessity, there must be recognition.

Sale/exchange of principal residence T may exclude $250k ($500 married) on gain from sale of principal residence if used for two of

previous five years (§121) If gain is attributable to depreciation (i.e. place was used for business), the gain is not excludible

Small business investment companies: nonrecognition of gain on sale of publicly traded securities if proceeds are invested in stock/partnership interest in “specialized small business investment” within 60 days. (§1044)

Qualified small business stock: T can defer recognition of gain on sale of qualified small business stock held for >6 months if T buys replacement stock in another qualified small business (§1045)

Bond risks: company doesn’t repay; market risk (interest rates go up); inflation risk; sometimes liquidity risk; foreign exchange risk (if bond is not in dollars)

When Is It Income or Deductible? (Accounting) Accounting method used on T’s books determines accounting method for tax purposes

Cash method: income taxed on receipt, deductions taxed when paid Accrual method: income taxed when earned, deduction taxed when owed

Exception: Secretary determines method if T’s does not clearly reflect income The taxable year

Burnet: T got judgment because co-contracting party had underestimated the costs of dredging a river. So T earned the money when dredged (1913-1916) but was not paid until judgment (1920). Had reported losses in earlier years because it had spent more doing the work than it had in income. Held: T had income in 1920, could not use it to offset losses from earlier years. Can’t combine years because IRS must assess taxes at some reasonable interval.

Taxable year is calendar year for most Ts. Can be fiscal year ending on last day of any other month. Short taxable year (T died, corporation dissolved/created) treated as full tax year

Tax benefit doctrine Inclusionary component: where T deducts from income in yr 1 and recovers that amount in yr 2,

the amount recovered must be in included in income in yr 2. Exclusionary component: where deduction in yr 1 produced no tax benefit, subsequent recovery

does not produce taxable income E.g. credits: If T took tax credit in yr 1 and had recovery in yr 2 of the item giving rise to the

credit, T must report income of the portion of the credit recovered in yr 2 (§111) Damage recoveries: if T earlier got no benefit from a contract/antitrust/patent infringement

loss, he can deduct it from the recovery when reporting income later BUT current tax rate applies, so if T’s bracket goes up, he pays more in tax later than he would

have paid earlier Hillsboro: where state refunded tax to shareholders (which corporation originally paid for them),

they had no income. Where company deducted cost of feed and then distributed it to shareholders, they had income. Tax benefit rule requires reporting income later where the receipt of money is inconsistent with the earlier position (if they had occurred in the same year, T would not get a deduction). Need not be “recovery.” Test: the deduction and later event are fundamentally inconsistent

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Can also be used to give T income where it was excluded earlier (e.g. bank with unclaimed deposits)

No statutory provision for recapture after conversion of business property to personal property Net operating loss deduction

T may apply a business loss incurred in one year against income earned in another year. Carry back a net loss 2 years and carry forward 20 years. (§172) Business loss only. Expense must be related to t/b. (plus casualty/theft losses)

Other capital losses carried forward only Married Ts on joint return can use NOL of one spouse’s business to offset income from other

spouse’s business, but no carry back to spouse’s business after that spouse died. No carryover to decedent’s estate, but can be carried back 3 yrs on T’s personal returns.

Mechanics for carry back: file refund claim to recover tax already paid for year past Methods of accounting

Cash method Cash method is default method (§451) Deductions, credits follow same method as income (§461) Can be used by qualified personal service corporations (activities in certain field, 95% of stock

owned by retired of current employees who perform the qualified activity) Constructive receipt doctrine

T has income when he has the immediate power to receive the income Carter: income earned by T in 1974 but not paid until 1975 was taxable in 1975 because he

did not have free, unrestricted control of the wages before receipt T not taxable on compensation he refuses to take No constructive receipt just because T could have arranged to receive payment earlier Escrow often shifts income to later years (unless escrow agent is payee’s agent only) Where funds embezzled and then returned, they were constructively received on return, not

when earned. Economic benefit/cash equivalent

Cash equivalent (actual receipt of property or right to receive property in the future) is taxable upon receipt Rev. Rul. 80-52: barter club members had income upon receipt of credits because they

were immediately useable to purchase other items/services. checks = cash. Some debate where T couldn’t cash the check in yr 1, e.g. received it on

Saturday Dec. 30 and bank closed until Jan. 2. Promissory note (if promisor is solvent and note is unconditional and assignable and of a

type frequently transferred to lenders) = cash Accounts receivable, non-negotiable notes, other debt instruments ≠ cash (this would turn

cash method into accrual method) The more liquid a note is, the more likely it will be treated as cash. no income on “unfunded, unsecured” promise to pay in the future

Pre-payments Boylston Market: cash-method T who prepaid insurance premiums must deduct pro rata over

the relevant years; deduction in the year of prepayment distorts income. Payment creates an asset with life beyond the current year. Pure cash method accounting rules give way to capitalization rules. Accrual method T who receives pre-payment must include it as income in the year

received. So prepayment is bad because payor must delay deduction and payee must include income immediately. Solution: structure as loan or deposit.

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Exception: prepayment for intangibles whose benefit lasts 12 months or end of the year following year of payment can deduct upon payment. Accrual-method payor can defer some advanced payments to succeeding year.

Cash method T must allocate and deduct prepaid interest over the loan period (§461(g)) IRS suffers where accrual method T makes deferred payment to cash method T. Payor takes

immediately deduction, payee delays inclusion of income. Addressed by matching rules, e.g. payments among related parties (§267), deferred rental

payments (§467), etc. Payor cannot take deduction until payee includes in income. Accrual method

More accurate reflection of economic gain Problem: incomes, deductions taken at stated amount, no discount to present value; also

liquidity problems for T if income earned now but not paid until later Payment accrues even if payment is unlikely (so no discount for risk or time)

Required for businesses with inventories “All events” test: all events have occurred which determine the fact of liability and the amount

of such liability can be determined with reasonable accuracy (§461(h)(4)) Hughes Props.: casino could deduct amounts guaranteed but not paid as payoffs on

progressive slot machines (casino will definitely be liable, and amount is at least what is guaranteed in the machine)

General Dynamics: self-insurer employer could not accrue employees’ expected medical costs until claims were filed even though the medical services had already been provided

Time value Ford Motor Co.: Ford could only deduct amounts of structured settlements that it paid in the

taxable year. Its method of deducting all amounts paid in the year plus all amounts due under periodic payment schedule did not “clearly reflect income.” Ford could exclude income from annuities and take an immediate deduction for the cost of the annuities that paid the settlements, rather than recovering under §72 (benefits Ford). Secretary determines a computation method that clearly reflects income (§446(b))

Problem is allowing a current deduction for a future expense. Mooney Aircraft (promise to pay $1k in 20 yrs; if deductible now, Mooney saves $350, investing at 6.5% yields more than $1k in 20 yrs, so Mooney makes a profit). If Ford could do it, they’d make a profit on killing people.

Economic performance (since 1984): accrual basis T can only deduct a liability when the events that give rise to the liability have taken place. E.g. A will pay B $100 in year 3 for performance of service in year 3. No deduction until year 3, despite a liability on the books. Accrual method T cannot deduct a tort liability until the year in which payment is made

(§461(h)(2)(c)). Same with awards, prizes, jackpots. Recurring items exception: T may deduct expenditures on recurring items as soon as “all

events” test is met, if economic performance occurs within 8.5 months after close of taxable year.

Installment method Where gain is uncertain (value or timing of satisfaction is uncertain), basis is recovered first (no

allocation of basis). Open transaction. Gain reported on “cost recovery” basis: payments applied first to basis and gain recognized after that point. Applies only to gains, not losses Not used on sale of inventory/real estate held for sale in the ordinary course of t/b, publicly

traded securities, or where the installment note itself can be publicly traded T can opt out of installment method (§453(d)) Result: tax deferral until basis is used up Installment sales between related parties: where purchaser disposes of the transferred property

within two years of the installment sale, the initial seller recognizes gain on resale of property to 30

the extent the amount realized on the second sale exceeds the actual payments made under the installment sale (§453(e))

Calculation: apply ratio (gross profit/total contract price) to each payment and tax that amount. The rest of each payment is recovery of basis. Gross profit = any cash received + any mortgage assumed + note value – basis

Do not include assumption of mortgage in contract price except to the extent it exceeds basis. (because T doesn’t have liquidity to pay when the consideration is only mortgage relief)

Disposition of installment obligation (sale, transfer, gift, cancellation, unenforceability) triggers recognition of any remaining gain. Does not apply to bequest or transfer between spouses upon divorce No step-up in basis of the installment obligation at decedent’s death Gain/loss recognized = T’s basis in the installment obligation – amount realized on

disposition T’s basis = face value of obligation – amount reported as income if obligation were

satisfied in full Property will only be determined to have no FMV in rare cases Where there is no stated maximum sale price or no fixed period for payment, the term will be 15

yrs If too speculative (open stream of percentage payments), treated as rents/royalties: then T

pays ordinary income on present payments (least advantageous) Imputed interest

Compound interest = economic = actuarial Original issue discount (OID): debt issue price is less than amount to be paid at maturity

Bonds issued with zero or below-market interest payable currently Lender reports annually the OID that accrues economically. Interest income. (§1272) Adjusted issue price at the beginning of the period * yield to maturity Add OID for each accrual period to the adjusted issue price of the bond and to the holder’s

adjusted basis Borrower deducts same amount as interest Puts both parties on accrual method for OID OID rules do not apply to tax-exempt debts, US savings bonds, or debts with term <1 yr; debts

between people if total loan is <$10k, loan isn’t part of lender’s trade/business, and no tax avoidance purpose

OID rules apply whenever there is unstated interest on a debt instrument (recharacterizes part of the sales price as interest). If debt instrument does not declare an interest rate, or states on less than the applicable federal rate (AFR), interest is imputed. Does not apply to sale of principal residence, debt instrument traded or issued for publicly

traded property, sale of patent where part of price is contingent on use, or sale of farm by individual/small business for ≤$1M (§483 applies to these, other than patents) §483: imputed interest allocated among principal payments under the contract using

economic accrual computation, but amounts are reported as interest by cash basis Ts at time of payment, not upon accrual

Use 6% interest rate to determine whether there is unstated interest on sales <$500k of land between related people

Market discount: bond’s stated redemption price > holder’s basis in the bond at the time of its acquisition value of debt declines after it is issued (usually because interest rates increase) Market discount treated as ordinary interest income on compound basis (§1276) Cash method Ts can report interest at bond disposition

Below-market demand loan (gift loan/loan payable on demand) (§7872(f))31

Each year loan is outstanding, amount of interest that would have been payable if the interest rate were the AFR is treated as if it were transferred by the lender to the borrower then retransferred to the lender as interest. E.g. employer-employee loan. Employee has income of the interest amount, employer

has deduction. Transfer back to employer is deductible to the employee only if the interest is deductible under §163.

Term loan: below-market if amount loaned > present value of all payments to be made under the loan, using the AFR on the date the loan is made. If the interest is too low, §7872 applies.

Deferred compensation Qualified plan: employer may deduct deferred compensation now and employees are taxed when

they receive the payment Qualified benefit plan: employee entitled to specified benefits; employer makes contributions

required to provide those benefits. Max $160k/yr benefit. Defined contribution plan: employer makes specific contribution, employee receives whatever

accumulates. Max $40 contribution. Nondiscrimination requirement: substantial number of lower-paid employees must participate

Nonqualified plan: employer can only include deduction when employee includes in income §409A: employee must include in income currently if:

he is protected against employer’s bankruptcy (e.g. money is in escrow) employee didn’t ask for deferral until the money was offered (must commit beforehand that

the money will remain in employer’s hands) Tax penalties for employees who withdraw pension funds before retirement IRAs: Roth paid with after-tax dollars, no tax on distribution; traditional paid with pre-tax dollars,

tax on distribution. Economically equivalent if tax rates are constant, but Roth permits larger accumulations ($5k after-tax contribution instead of the after-tax equivalent of $5k pre-tax)

401(k)/403(b) etc.: optional salary reduction plans (pre-tax saving) ISOs (§421(a)(1))

Non-ISO treatment: income on exercise (stock price when option exercised - stock price when option granted); capital gains on subsequent sale; or if option is publicly traded, then income on receipt of option, no income on exercise, and capital gains on sale

ISO: Not taxable when granted/exercised; basis is price at exercise; capital gains on sale. No deduction to employer.

Option price cannot be less than FMV of the underlying stock when the option is granted. Employee may not dispose of stock within 2 yrs of receipt or one yr of exercise. Option term cannot be > 10 yrs. Option cannot be transferable.

ISOs are treated as non-ISO for AMT. tax on (sales price – exercise price). Corporate Tax Shelters

Criticism: short-term revenue loss, promotes disrespect for the system and others perceive unfairness, increases complexity in response to abuses, uneconomic use of resources (IRS time, money; accountant/lawyer time, money)

Hard to define. Usually use lack of economic substance, inconsistent financial accounting and tax treatments, tax-indifferent parties involved, marketing activity of the scheme, confidentiality required, contingent promoter fees based on level of tax savings realized, high transaction costs

ACM: 3d Cir. used two-pronged economic substance test: subjective (business purpose) and objective (practical economic effects other than creating tax losses). Abusive tax shelter present where ACM invested in Citicorp notes that would not have greater return than a bank account (loss on LIBOR notes is not “economic substance” because Colgate could have accomplished this without the Citicorp transaction), ACM planned the transaction with no regard to pre-tax economic benefit and there was no reasonably anticipated pre-tax profit especially given the high transaction costs. Cottage Savings allowed the loss because there was real loss, not artificial. Here, the loss was

artificial and created during the transaction. There, the loss occurred in the market.32

Test looks for unnecessary transaction features that create artificial losses or boost basis artificially but have no reasonable potential for profit after transaction costs.

Shelter users usually protected against penalty if they have a legal opinion letter stating that the shelter does not violate law.

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