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Fed Tax Outline Lizzie Douglas

Table of Contents I. Code Sections Summary Tables 4

A. Code Sections Listed Sequentially By Section Number 4B. Code Sections Listed Sequentially by Coverage/Topic 6

II. Formula/Definitions/Steps for Solving Problems 8A. The Tax Base 8B. Average & Marginal Rates 8C. Accrual Method Taxpayers 8D. Present/Future Value Equation 8E. Definitions from Case Law 9F. Installment Sales Method 9G. Accelerated Depreciation Method 9H. Like-Kind Exchanges 10I. Excess Alimony 10

III. Some Characteristics of Income 10A. Noncash Benefits 10

1. Section 119: Meals or Lodging Furnished for the Convenience of the Employer 112. Section 132: Certain Fringe Benefits 113. Case Summaries 11

B. Imputed Income 12C. Windfalls and Gifts 12

1. Section 102: Gifts and Inheritances 122. Section 117: Scholarships 133. Transfers of Property 134. Section 1015: Basis of Property Acquired by Gift 135. Section 1014: Basis of Property Acquired from Decedent 136. Case Summaries 13

D. Recovery of Capital 151. Life Insurance 152. Annuities and Pensions 153. Gains and Losses from Gambling 164. Case Summaries 16

E. Annual Accounting and Its Consequences 171. Section 172: Net Operating Loss Deduction 172. Section 1341: Restoration of a Substantial Amount Held Under Claim of Right 173. Section 111: Recovery of Tax Benefit Items (Tax Benefit Rule) 174. Case Summaries 18

F. Section 104: Recoveries for Personal and Business Injuries 19G. Transactions Involving Loans and Income from COD 20

1. Loan Transactions and Cancellation of Debtedness (COD) 202. Section 108: Income from Discharge of Indebtedness (Relief Provision) 203. Transfer of Property Subject to Debt 204. Case Summaries 21

H. Illegal Income 221. Case Summaries 22

I. Interest on State and Local Bonds 23J. Section 121: Gain on the Sale of a Home 23

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IV. Problems of Timing 23A. Gains and Losses from Investment in Property 23

1. Case Summaries 23B. Statutory Nonrecognition Provisions 25

1. Section 1031: Like-Kind Exchanges 252. Basis 26

C. Section 1259: Constructive Sales 26D. Section 1273: Original Issue Discount 26F. Open Transactions and Installment Sales 27

1. Section 453: Installment Sales 272. Case Summaries 28

G. Constructive Receipt and Related Doctrines 281. Basic Principles: Constructive Receipt and Economic Benefit 282. Deferred Compensation 293. Stock Options and Other Restricted Property 29

a. Section 422: Incentive Stock Options 30b. Section 83: Nonstatutory Stock Options 30

4. Case Summaries 30H. Transfers Incident to Marriage and Divorce 32

1. Case Summaries 33I. Cash Receipts and Payments of Accrual-Method Taxpayers 34

1. Accrual Accounting of Income 342. Uncertain Collections 343. Advance Receipt for Goods and Service 344. Deposits, Loans, and Trust Funds 345. Accrual Method: Liabilities 356. Case Summaries 35

V. Personal Deductions, Exemptions, and Credits 36A. Section 165(c): Casualty Losses 37

1. Case Summaries 37B. Section 170: Charitable Contributions 39

1. Case Summaries 39C. Section 163: Interest 40D. Section 164: Taxes 40E. Section 151: Personal and Dependency exemptions 41

VI. Allowances for Mixed Business and Personal Outlays 41A. Sections 162 and 212: Ordinary and Necessary Expenses 41B. Controlling the Abuse of Business Deductions 41

1. Section 183: Hobby Losses 412. Section 280A: Home Offices and Vacation Homes 423. Case Summaries 42

C. Section 274: Travel and Entertainment Expenses 441. Case Summaries 45

D. Sections 21 and 129: Child-Care Expenses 451. Case Summaries 45

E. Commuting Expenses 461. Case Summaries 46

F. Clothing, Legal, and Education Expenses 471. Case Summaries 47

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VII. Deductions for the Costs of Earning Income 48A. Current Expenses Versus Capital Expenditures 48

1. Capitalization Theory 482. Section 263A: Uniform Capitalization Rules 483. Case Summaries 49

B. Repair and Maintenance Expenses 491. Case Summaries 50

C. Section 471: Inventory Accounting 50D. “Ordinary and Necessary” 50

1. Section 162: “Ordinary and Necessary” Requirement 512. Reasonable Compensation 513. Case Summaries 51

E. Depreciation 521. Straight Line Depreciation 522. Accelerated Depreciation: 150% and 200% 523. Sections 167 & 168: Depreciation 52

F. The Alternative Minimum Tax 531. Computing AMT Liability 531. Case Summaries 53

VIII. Tax Progressivity and Splitting of Income 54A. Income From Services: Diversion by Operation of Contract or Law 54

1. Case Summaries 54B. The Marriage Penalty and Bonus 54C. Transfers of Property and Income from Property 55

1. Case Summaries 55

IX. Capital Gains and Losses 55A. Background and Statutory Framework 55

1. Capital Gains and Losses 552. Section 1(h): Capital Gains Rate 563. Section 1211: Net Capital Loss 564. Section 1222: Net Capital Gain 575. Section 1221: Capital Asset 576. Section 1231: Property Uses in a Trade or Business 57

B. Property Held “Primarily for Sale to Customers” 571. Case Summaries 57

X. Tax Compliance and Penalties 58A. Tax Compliance 58B. Defenses for §6662 & §6663 Penalties 58C. How sure do you need to be? 59

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I. Code Sections Summary Tables

A. CODE SECTIONS LISTED SEQUENTIALLY BY SECTION NUMBER Code

Section Topic Page #sProblem Set

1(h) Capital Gains Rate 521 Credit for Child Care Expenses 1232 Earned Income Tax Credit 2861 Gross Income Defined 5062 AGI Defined 5063 Taxable Income Defined 5468 Overall Limitation on Itemized Deductions 5971 Alimony is Includible in Income 60 (1040) 22

72Annuity Payments Includable Above the "Exclusion Ratio" 62 9

83 Nonstatutory Stock Options 76 (1052) 21101 Death Benefits Excluded 80102 Gifts and Inheritances Excluded 84 (1067) 7103 Interest on Municipal Bonds Excluded 84104 Compensation for Injuries or Sickness 85 (1068) 10108 Income from the Discharge of Indebtedness (Relief) 88 12109 Improvements by Lessee Excluded from Income 96111 Recovery of Tax Benefit Items 96117 Qualified Scholarships 98 (1070) 8119 Meals or Lodging 99 (1074) 5121 Exclusion of Gain from Sale of Principal Residence 101 (1077) 13129 Dependent Care Assistance Programs 112132 Certain Fringe Benefits 115 (1087) 5148 Arbitrage Bonds 132151 Personal and Dependency Exemptions 133

162 Deductions for Trade or Business Expenses 139 (1106)28, 29, 30

163 Interest Deductions 144 (1126) 25164 SALT Deductions 154

165(c) Casualty Losses 157 (1140) 23165(d) Losses from Gambling are Basketed 168

167 Depreciation Deductions 160 DP168 Accelerated Cost Recovery System 163170 Charitable Contributions 178 25172 Net Operating Loss Deduction 197183 Basketing of Hobby Losses 207 (1181) 26197 Amortization Deductions 211212 Deductions for Expenses for Production of Income 219

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215 Alimony is Deductible 222 22262 No Deduction for Personal, Living, & Family Expenses 245263 Capital Expenditures 246 31

263A Uniform Capitalization Rules 246264 Life Insurance & Annuity Premiums Not Deductible 250265 Expenses and Interest Relating to Tax-Exempt Income 251 13274 Travel and Entertainment Expenses 274 28

280A Home Offices and Vacation Homes 268382 Limit on Trafficking NOLs 334422 Incentive Stock Options 364 21451 Cash Method & Accrual Accounting for Income 375 (1486)453 Installment Method 376 (1488) 18455 Prepaid Subscription Income 386461 Accrual Accounting for Liabilities 387 (1501)465 Deductions Limited to Amount at Risk 390471 Inventory Accounting 406

1001 Amount of and Recognition of Gain or Loss 523 (1740)1011 Adjusted Basis for Determining Gain or Loss 524 (1745)1012 Basis of Property - Cost 524 (1746)1014 Basis of Property Acquired from a Decedent 525 (1751)1015 Basis of Property Acquired by Gift 527 (1754) 81019 Improvements by Lessee Doesn't Affect Owner's Basis 5311031 Exchange of Like-Kind Property 532 (1760) 15

1041Transfer of Property Between Spouses or Incident to Divorce 539 22

1211 Net Capital Loss 5541221 Capital Asset 5571222 Net Capital Gain 5591231 Property Used in Trade or Business 5611259 Constructive Sales 5851272 OID Included in Income 5891273 Determination of Amount of OID 592

1274Determination of Issue Price for Certain Debt Instruments 593

1341Restoration of Substantial Amount Under Claim of Right 610

3402 Withholding 6456012 Persons Required to Make Returns of Income 6516501 Audit within 3 years of tax filed 6816662 Accuracy-Related Penalty on Under-Payments 6996663 Imposition of Fraud Penalty 7037201 Criminal Penalties for Tax Evasion 7127203 Criminal Penalties for Failure to File a Return 712

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B. CODE SECTIONS LISTED SEQUENTIALLY BY COVERAGE/TOPIC Code

Section Topic Page #sProblem Set

6012 Persons Required to Make Returns of Income 65161 Gross Income Defined 5062 AGI Defined 5063 Taxable Income Defined 54

119 Meals or Lodging 99 (1074) 5132 Certain Fringe Benefits 115 (1087) 5102 Gifts and Inheritances Excluded 84 (1067) 7117 Qualified Scholarships 98 (1070) 8

1001 Amount of and Recognition of Gain or Loss 523 (1740)1011 Adjusted Basis for Determining Gain or Loss 524 (1745)1012 Basis of Property - Cost 524 (1746)1014 Basis of Property Acquired from a Decedent 525 (1751)1015 Basis of Property Acquired by Gift 527 (1754) 8101 Death Benefits Excluded 80264 Life Insurance & Annuity Premiums Not Deductible 250

72Annuity Payments Includable Above the "Exclusion Ratio" 62 9

165(d) Losses from Gambling are Basketed 168172 Net Operating Loss Deduction 197

1341Restoration of Substantial Amount Under Claim of Right 610

111 Recovery of Tax Benefit Items 96104 Compensation for Injuries or Sickness 85 (1068) 10108 Income from the Discharge of Indebtedness (Relief) 88 12121 Exclusion of Gain from Sale of Principal Residence 101 (1077) 13148 Arbitrage Bonds 132103 Interest on Municipal Bonds Excluded 84265 Expenses and Interest Relating to Tax-Exempt Income 251 13109 Improvements by Lessee Excluded from Income 96

1019 Improvements by Lessee Doesn't Affect Owner's Basis 5311031 Exchange of Like-Kind Property 532 (1760) 151272 OID Included in Income 5891273 Determination of Amount of OID 592

1274Determination of Issue Price for Certain Debt Instruments 593

453 Installment Method 376 (1488) 1883 Nonstatutory Stock Options 76 (1052) 21

422 Incentive Stock Options 364 211041 Transfer of Property Between Spouses or Incident to 539 22

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Divorce1259 Constructive Sales 585215 Alimony is Deductible 222 2271 Alimony is Includible in Income 60 (1040) 22

455 Prepaid Subscription Income 386465 Deductions Limited to Amount at Risk 390461 Accrual Accounting for Liabilities 387 (1501)451 Cash Method & Accrual Accounting for Income 375 (1486)68 Overall Limitation on Itemized Deductions 59

165(c) Casualty Losses 157 (1140) 23170 Charitable Contributions 178 25163 Interest Deductions 144 (1126) 25164 SALT Deductions 154151 Personal and Dependency Exemptions 133

162 Deductions for Trade or Business Expenses 139 (1106)28, 29, 30

212 Deductions for Expenses for Production of Income 219262 No Deduction for Personal, Living, & Family Expenses 245183 Basketing of Hobby Losses 207 (1181) 26

280A Home Offices and Vacation Homes 268274 Travel and Entertainment Expenses 274 2821 Credit for Child Care Expenses 12

129 Dependent Care Assistance Programs 112263 Capital Expenditures 246 31

263A Uniform Capitalization Rules 246471 Inventory Accounting 406167 Depreciation Deductions 160 DP168 Accelerated Cost Recovery System 163197 Amortization Deductions 2111(h) Capital Gains Rate 5

1211 Net Capital Loss 5541221 Capital Asset 5571222 Net Capital Gain 5591231 Property Used in Trade or Business 5616662 Accuracy-Related Penalty on Under-Payments 6996663 Imposition of Fraud Penalty 7037201 Criminal Penalties for Tax Evasion 7127203 Criminal Penalties for Failure to File a Return 712

II.Formula/Definitions/Steps for Solving Problems

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KeyRules Underlying ValuesCasesTerms of ArtHayashi’s Opinion/Exam HintReviewProblem SetTextbookChirelstein Supplement


A. THE TAX BASE Haig-Simons definition of income: Y = C + ΔW Haig-Simons income > gross income (§61) > AGI (§62) > taxable income (§63) all these are possible tax bases Haig-Simons income (C + ΔW) doesn’t equal gross income (§61) definition of gross income

o §61(a) is extremely broad (illustrative list)o §61(b) cross references to things specifically included (§71 et. seq.) and excluded

(§100 et. seq) gross income §61 > AGI §62 most important above the line deductions are trade and business deductions in §62(a)(1) AGI §62 > taxable income §63

B. AVERAGE & MARGINAL RATES average tax rate: total tax/gross income marginal tax rate: statutory tax rate applicable to the next dollar of taxable income marginal effective tax rate:

o (tax change from $1 of gross income)/($1 of gross income)o probably the best metric for determining tax incentives “all things considered

cost” progressive tax: average tax rate goes up as gross income increases regressive tax: average tax rate goes down as gross income increases proportional tax: average tax rate stays constant as gross income increases

C. ACCRUAL METHOD TAXPAYERS income taken into account for an accrual method taxpayers (§451)

1. all events occur that give rise to right of payment2. amount can be determined with reasonable accuracy

liabilities (i.e. deductible expenses) taken into account for accrual method (§461)1. taxable year in which all the events have occurred that establish the fact of the

liability2. the amount of the liability can be determined with reasonable accuracy3. economic performance has occurred with respect to liability

D. PRESENT/FUTURE VALUE EQUATION

PV= FV(1+ i )n

E. DEFINITIONS FROM CASE LAW income is “undeniable accessions to wealth, clearly realized, and over which the

taxpayers have complete dominion” (Glenshaw Glass) gifts test: look at donor’s intent to see if transfer is made out of a “detached and

disinterested generosity” or “out of affection, respect, admiration, charity and like impulses” (Duberstein)

claim of right doctrine: “If a taxpayer receives earnings under a claim of right and

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without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent” (North American Oil Consolidated v. Burnet)

F. INSTALLMENT SALES METHOD 1. calculate selling price and contract price

a. selling price is equivalent to amount realizedb. contract price is the amount of cash payments received + (amt debt assumed

exceeds adjusted basis)c. will be the same unless property subject to debt

2. calculate gross profit: selling price – adjusted basis3. calculate gross profit ratio: gross profit/contract price4. calculate gain on payments (gross profit ratio x payment)

if the T disposes of the installment obligation for something other than its face value then: gain or loss: amount realized on the sale of the note – the seller’s basis in the obligation basis in the obligation: excess of the face value of the obligation over an amount equal to

the income which would be returnable were the obligation satisfied in full see §453B

§453 does not apply to sales of stock or securities traded on an established securities market (§453(k)(2)(A))

G. ACCELERATED DEPRECIATION METHOD 1. Calculate % of property’s basis depreciated in year 1 under the straight line method. 2. Multiply that percentage by 2 or 1.5. Call this new percentage X%. 3. Every year, calculate the depreciation deduction that would be taken if the property were

depreciated on a straight line basis over its remaining useful life treating it like property acquired new and placed into service that year (for each year of useful life)

4. Depreciate in that year at the greater of the number in (3) or X% of the basis. 5. Reduce the property’s basis for the depreciation.

H. LIKE-KIND EXCHANGES No recognition on exchange of LK properties if both for use in ToB/investment

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Gain realized = AR – AB. §1001(a). AR = cash + FMV property received + amount of liabilities discharged. See 1.1001-2(a). AB = adjusted basis in property exchanged Gain recognized: to the extent of boot. §1031(b). Assumption of debt by the other party

is boot. 1.1031(b)-1(c). Basis in new LK property = basis in transferred LK property + net cash paid + net

liabilities assumed + basis in boot property transferred – FMV boot property received + gain recognized – loss recognized

discharge of liabilities included in amount realized (unless buyer cancels debt, then that is COD income)

if both parties had liabilities, offset liabilities in determination of boot (§1.1031(b)-1(c))

I. EXCESS ALIMONY where:

Y1 = alimony in Year 1 Y2 = alimony in Year 2 Y3 = alimony in Year 3 E1 = excess for Year 1 E2 = excess for Year 2 E = excess alimony for which payor has to include and payee has to deduct

E 2=Y 2−(Y 3+15)

E 1=Y 1−(Y 2−E 2+Y 32

+15)

E=E 1+E 2

III. Some Characteristics of Income

A. NONCASH BENEFITS

1. Section 119 : Meals or Lodging Furnished for the Convenience of the Employer provides exclusion from gross income lots of litigation around terms in section exclusion is applicable to gross income of employee possibly included on spouse’s or

dependent’s returns Treas. Reg. §1.119-1(a)(2) fills in gaps of §119

o substantial noncompensatory business reason furnished for convenience of employers

o means of providing compensation not furnished for convenience of employer under §119, following criteria must be met to exclude:

o meals furnished for the convenience of the employer on the business premises of employer

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o lodging furnished for the convenience of the employer lodging on the business premises of employer required to accept lodging as a condition of employment

2. Section 132 : Certain Fringe Benefits §132: certain fringe benefits excluded from gross income ex 1: Steven is paid to do lighting at Live Arts performance. On days off, he is allowed to

take in a show for free on a space-available basis. Gross income?o no, excluded under §132(b)

ex 2: Pete is paid to draw the chalk lines at UVA football games. He is given free seats to the game on a space-available basis. Gross income?

o no, excluded under §132 §132(d): working condition fringe

o excluded from income if (counterfactually) would have been deductible if T had paid for it himself

o from employer’s perspective, either deductible as business expense or salary §132(d) and §162 linkage simplifies accounting

3. Case Summaries TOPIC AREA CASE NAME KEY FACTS TAKE HOME

Non-Cash Benefits

Bengalia v. Commissioner (1937)

Bengalia was a hotel manager for a chain of hotels and he and his wife lived at one of the hotels and received free room and board. They did not pay tax on the fair market value of this room and board. The Commissioner added what he deemed fair market value of the room and board to the Bengalia's tax returns for the years they received this.

Whether a non-cash benefit is income depends on the intent of the employer (among other things).

HOLDINGSince the free room and board was for the convenience of the employer and not the employee, it does not count as income for the employee.

Prizes Turner v. Commissioner (1964)

Reginald won a prize of two first-class steamship tickets for a cruise between NYC and Buenos Aires on a radio show. He and his wife traded these two tickets for four tourist class tickets for NYC to Rio de Janeiro. The market value of the original tickets

This non-cash prize was income, but the court wasn’t clear about how to calculate their value.

HOLDINGThe petitioners have to pay tax on the

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tickets (but the court isn't clear how it got to $1400).

was $2220 and the value of the traded tickets to the Turners was $1400. The petitioners filed a return reporting an income of $4535.16 for 1948. This included $520 representing the radio show prize. The Commissioner determined a deficiency of $388.96.

B. IMPUTED INCOME lack of observable transaction in-kind benefits are consumed by employees fit w/in H-S definition under H-S, homeowners also consumer their own home because it doesn’t matter who

they are renting from but we don’t tax imputed income so this incentivizes people to invest in owner-occupied

homes

C. WINDFALLS AND GIFTS

1. Section 102 : Gifts and Inheritances gifts excluded from gross income under §102 alternative treatment?

o income to recipient and deduction to giver comports with H-S definition ignores value of gift-giving to give treats transfers between family members as taxable events and thus allows

families to reduce tax liabilityo income to recipient and no deduction

benefit to recipient captured under HS and benefit to giver makes gift-exchanges hard (Christmas is tricky)

o no income to recipient and no deduction ignores inter-family transfers and benefit to recipient requires sharp distinction between gifts and other economic transfers

departure from H-S definition of income administrative concessions that we don’t tax gifts if we did, people could use

deduction to game system (ex. high income parents give cash to minor children) statute doesn’t define gifts defined by courts Duberstein

o intent of donor detached and disinterested generosity given out of affection, respect, admiration, charity or like impulses

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o courts look to objective evidence of donor’s state of mind won’t just take donor’s word for it

2. Section 117 : Scholarships §117: general rule excludes scholarships §117(c): limits this general rule and creates a fair amount of uncertainty in the statute

3. Transfers of Property §61(a)(3): GI includes gains from dealings in property Reg §1.61-6

o taxed on realized gaino calculate this following §1001

§1001(a)o gain = excess of amount realized – adjusted basis (§1011)o loss = excess of adjusted basis (§1011) = amount realized

§1001(b): amount realized = money + FMV of property §1001(c): realization = recognition unless specific non-recognition provision applies §1011: adjusted basis = basis (§1012) + adjustments (§1016) §1012: basis = cost of property except otherwise provided

4. Section 1015 : Basis of Property Acquired by Gift §1015 provides rules for determining basis if property acquired by gift basis = basis of donor except if basis > FMV, then basis for determining loss is FMV

5. Section 1014 : Basis of Property Acquired from Decedent §1014 is an exception to the principle of the conservation of basis result taxpayers

wanted in Taft §1014

o general rule: basis is FMV at date of deatho alternative rule: basis is FMV 6 months after death


Punitive Damages Commissioner v. Glenshaw Glass (1964)

In both cases, the plaintiffs had reached a settlement in antitrust litigation and a portion of this settlement was punitive damages. Neither plaintiff reported the punitive damages portion as gross income. In both cases, the Tax Court and the Third Circuit found for the plaintiffs.

SCOTUS adopts the liberal definition of income as “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” (and rejects the more narrow definition in Eisener v. Macomber).

HOLDINGReversed. Punitive damages must be included in gross income. Overturns narrow definition of income in Eisner v.

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Macomber.Gifts Commissioner v.

Duberstein (1960)No. 376: Dubertsein received a Cadillac from a business associate because the acquaintance appreciated some information Duberstein had given him. The Tax Court said Duberstein had to pay tax and the Sixth Circuit reversed.

No. 506: Stanton had received money, described as a "gift" from his employer when he left the company. The trial court found that the money was a gift and the Second Circuit reversed.

Whether something is a gift or not is a fact intensive inquiry. Look at donor’s intent to see if transfer is made out of a “detached and disinterested generosity” or “out of affection, respect, admiration, charity and like impulses.”

HOLDINGNo. 376: Reversed. The Tax Court was correct that the car was income.

No. 546: Remanded for fact finding about whether or not this was a gift.

Gifts US v. Harris (1991) Conley and Harris were mistresses of Kritzik (now deceased). Over the course of several years, Kritzik gave them more than half a million dollars. Neither sister paid income tax on this money and Kritzik did not pay gift tax. At separate criminal trials, the sisters were convicted of tax evasion. They then appealed.

Whether something is a gift or not completely turns on intent of donor and not recipient.

HOLDINGReversed and convictions vacated.

Gifts Taft v. Bowers (1929)

1916: A bought 100 shares of stock for $1000. 1923: The value of the stock was $2000 and A gave them to B. B then sold the stock for $5000. The US argued that B had to pay income tax on $4000, whereas B argued that the income tax should be assessed on $3000. The District Court found for the taxpayer. The Appeals Court reversed and found for the US.

The principle of the conservation of basis: the gift recipient inherits the basis of the donor.

HOLDINGUpheld. The taxpayer should be assessed for $4000.

D. RECOVERY OF CAPITAL

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capital is recovered only once: “conservation of basis” §1014 breaks this rule for decedent giving property on death

o if has loss, sell before deatho if has gain, give after deatho §1014(e) prevents people using a decedent as a way to step up basis

1. Life Insurance proceeds are excluded under §101 premiums are not deducible under §264(a)(1) doesn’t follow H-S principles

o in the aggregate, there is no real gains or losses for term life insuranceo in individual cases of term life insurance, this doesn’t match economic reality

savings/investment component embedded in life insurance contracts advantageous because benefits not taxed

example p115, n16: o There are three people, Alice, Bob, and Carol, each of whom has a life expectancy

of 14.5 years and each of whom buys, for $25k, a single-premium life insurance policy with a death benefit of $100k. The interest rate at which $25k grows to $100k in 14.5 years is 10%.

o This is how it bans out if Alice dies at 14.5 years, Bob dies the day after he buys the policy, and Carol lives 25 years:

Life Span Investment Grows to

Death Benefit

Investment Gain or Loss

Mortality Gain or Loss

Alice 14.5 $100k $100k $75k $0Bob 0 $25k $100k 0 $75k

2. Annuities and Pensions convert some wealth into a fixed stream of income for the rets of your life types

o payout schedule: deferred or regularo payout amount: fixed or variable

tax ruleso §264(a)(1): premium not deductibleo §72(a): payment includable, but only above “exclusion ratio” (investment in

contract/expected return under contract)o if die before recover basis, then include unrecovered basis as a loss in final tax

return

3. Gains and Losses from Gambling consumption element in gambling loss because derive fun from playing games but the law doesn’t take this approach: §165(d)

o gains from gambling are incomeo losses from gambling are only allowed to deduct from gambling gains

“basketing”

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Recovery of Capital

Inaja Land Co. v. Commissioner (1947)

Petitioner bought land on the banks of a river along with water rights. Los Angeles diverted water onto the property and adversely affected the land. The petitioner and city reached a settlement in which the petitioner was paid $50,000 (minus $1000 in lawyers fees) to release the city from any liability and grant an easement to continue the diversion of water.

This case is all about timing and whether Inaja could defer payment of the tax (and not about how much tax he actually owed).HOLDING

The payment should be considered as a return of capital and reduce the cost basis rather than be treated as income.

Recovery of Loss Clark v. Commissioner (1939)

In 1932, petitioner and his wife filed jointly as per the advice of their tax counsel. They were audited and assessed an additional sum based on a sale of capital assets. If the tax counsel hadn't calculated the tax return improperly, he should have advised the petitioner and his wife to file separately and reduce their tax liability by $19,941.10. The tax counsel paid that amount to the petitioner. The IRS included this amount as income on the petitioner's 1934 tax return.

Rule of Thumb: If loss

deductible, then recovery is income.

If loss not deductible, then recovery is not income.

HOLDINGThe amount is not includible in gross income.

E. ANNUAL ACCOUNTING AND ITS CONSEQUENCES annual accounting leads to higher tax liability for more volatile income certain rules (such as NOL carryover) seek to smooth out the edges this creates

1. Section 172 : Net Operating Loss Deduction §172 allows tax attributes from year to year (attributes = jargon for basis, credits, NOLs,

etc. – see §108(b) for list) NOLs can go back for 2 years or forward 20 years value of NOL depends on marginal effective tax rate

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§382(b): bans trafficking in losses (and other attributes), as well as other sneaky behaviour

o example: if more than 50% of ownership changes hands in less than 3 years, then cap on use of NOL

2. Section 1341 : Restoration of a Substantial Amount Held Under Claim of Right restoration of substantial amount of loss Congress responded to Lewis by enacting §1341 section has special rules for computation of tax where taxpayer restores substantial

amount under claim of right if tax rate increases from Y 1 to Y2, taxpayer can receive a windfall this rule is thus taxpayer favourable example:

1341(a)(4) 1341(a)(5)

2012 2013 2012 2013

Wages $100,000 $100,000 $100,000 $100,000

Bonus $20,000 -$20,000 -- $0

Taxable income $120,000 $80,000 $100,000 $100,000

Rate 30% 20% 30% 20%

Tax $36,000 $16,000 $30,000 $20,000

Reduction $6,000 $6,000

Final Tax $36,000 $16,000 $14,000

3. Section 111 : Recovery of Tax Benefit Items (Tax Benefit Rule) deals with opposite situation as claim of right: Clark situation §111 has exclusionary and inclusionary aspects the general rule is exclusionary §111(c) prevents using NOL carryovers in §111(a) not as favourable as claim of right rule in §1341 if rates go up, have to pay more than

would


Recovery of Loss Clark v. Commissioner (1939)

In 1932, petitioner and his wife filed jointly as per the advice of their tax counsel. They were audited and assessed an additional sum based on a sale of capital assets. If the tax counsel hadn't calculated the tax return improperly, he should

Rule of Thumb: If loss

deductible, then recovery is income.

If loss not deductible, then recovery is not income.

HOLDINGThe amount is not includible in gross

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income. have advised the petitioner and his wife to file separately and reduce their tax liability by $19,941.10. The tax counsel paid that amount to the petitioner. The IRS included this amount as income on the petitioner's 1934 tax return.

Consequences of Annual Accounting

Burent v. Sanford & Brooks Co. (1939)

From 1913-195, the R had a contract to dredge the Delaware River for the Atlantic Dredging Company. In 1913, 1915, and 1916, the R had net losses. In 1914, it had no net income. In 1915, work stopped and a breach of warranty claim was brought. The R recovered expenses and interest in that suit, but didn't include the amount as gross income in its tax return for 1920. The IRS said both parts should have been included in gross income. The court of Appeals ruled that only the interest was income and the recovered expenses was a return of losses.

The problem in Sanford is fixed by the carryover of NOL (§172), but this is an exception to annual accounting rules. If annual accounting was followed strictly, then the Sanford problem would arise frequently.

HOLDINGRecovery of loss was income in 1920.

Claim of Right North American Oil Consolidated v. Burnet (1932)

The US had instituted a suit against the P in 1916 over a piece of oil land. During the duration of the suit, a receiver operated the property. The 1916 profits from the land were paid to the P in 1917 after the District Court dismissed the case. The US continued to litigate, until it lost in 1922. The P included the income on its amended tax return for 1916, filed in 1918. After an audit in 1917, the IRS determined there was a

Claim of Right doctrine: “If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to

HOLDINGAffirmed. The amount was taxable to the firm in 1917.

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deficiency. The P appealed to the Tax Court. In 1927 the Tax court held that the profits were taxable to the receiver as income in 1916. The Circuit Court held that the profits were taxable to the P as income in 1917.

restore its equivalent.”

Claim of Right US v. Lewis (1951) Lewis was paid a bonus of $22k in 1944 and paid income tax on it. As a result of a subsequent litigation, Lewis was required to pay $11k back to his employer who had miscalculated the bonus. The Court of Claims said that the excess bonus was a "mistake of fact" and was not income in 1944 and therefore a refund should be based on the recalculation of that year.

The claim of right doctrine is premised on administrative efficiency and the need for finality. Congress enacted §1341 to fix the situation Lewis faced.

HOLDINGReversed. Lewis should put down the money as a loss in 1944 and not receive a recalculation.

F. SECTION 104 : RECOVERIES FOR PERSONAL AND BUSINESS INJURIES for business loses, damages (inc. punitive) are generally taxed in the year received

includes damages from court award, settlement, and/or insurance for individuals, amounts are generally excludable to the extent that the amounts are

attributable to personal injury generally, ED not excludable, but medical expenses arising from ED are excludable recovers for injuries: generally need a physical injury hook evidentiary reason

G. TRANSACTIONS INVOLVING LOANS AND INCOME FROM COD

1. Loan Transactions and Cancellation of Debtedness (COD) in general, loans are not income and not deductible this is based on assumption lender

has full recourse to secure loan against all of borrower’s assets recourse loan: lender can derive satisfaction from borrower’s assets nonrecourse loan: lender can’t look to other assets of borrower for satisfaction §61(a)(12): discharge of indebtedness is income

2. Section 108 : Income from Discharge of Indebtedness (Relief Provision) exclusions from what would otherwise by COD income §108(a)(1)(E): “qualified principal residence indebtedness” not included in income

enacted after 2007 in response to subprime mortgage crisis (ran out on January 1, 2015 after having been extended by Congress multiple times)

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other exclusion exampleso –(A): Ch 11 bankruptcyo –(B): insolvency

§108(d) defines all these terms there is a price to pay for this exclusion: reduction of tax attributes under §108(b)

o if COD excluded under §108(a)(1)(A), -(B), or –(C), then tax attributes must be reduced

o ordering of reductions given in –(b)(2)o how much? -(b)(3)

1 dollar of exclusion = 1 dollar of reductions for NOLs 1 dollar of exclusion = 0.335 dollar of credit reductions (-(b)(2)(B), -(C),

and –(G)) implicit 33% marginal tax rate will be over/under inclusive, but administratively efficient

3. Transfer of Property Subject to Debt if transfer of property and transferee assumes some of the debt, that will be part of the

amount realized (unless excluded under §108) depreciation and basis : deduction for predictable decline in value of business asset

exception to realization requirement (because usually don’t realize loss until disposition of property)

debt and basis :o acquisition debt included in the basis of property and discharge of debt included

in amount realizedo this is true, regardless of whether debt is recourse or nonrecourse

depreciation, debt, basis and sales: 1. depreciation deductions reduce basis2. purchaser’s initial basis in property is cost, regardless of any debt incurred to buy

property3. amount realized includes debt assumed by buyer


Cancellation of Debtedness

US v. Kirby Lumber (1931)

Kirby issued its own bonds in 1923 for $12mil. In the same year it purchased $1mil of these bonds for $862,000, thus saving $138,000.

The reasoning of Kirby Lumber is no longer good, but the holding is: COD is income.

HOLDINGReversed. Have to pay tax on the income.


Zarin v. Commissioner (1990)

Zarin was a gambling addict who was extended numerous lines of credit by the casino Resorts. The credit practices Resorts was using were against NJ regulations and later to be found illegal.

HAYASHI says the court’s reasoning in this case doesn’t really work. A better theory would be that the chips were property, and

HOLDINGZarin didn't realize any income from

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his settlement with Resorts.

Resorts sued Zarin for the approx. $3.5 mil he owed them and Zarin denied liability on the grounds that the claim was unenforceable. In 1981, Resorts and Zarin settled their dispute for $500k. Initially the IRS determined a deficiency of $3.5mil in Zarin's 1980 tax return. Zarin challenged this in Tax Court, and the IRS argued instead that he had approx $3 mil of income from the cancellation of indebtedness. The Tax Court agreed and held that this counted as income. This meant Zarin deficiency was about $2mil since he was in the seventy percent tax bracket. Including interest, Zarin allegedly owes $5mil.

therefore a price reduction under §108(e)(5).


Diedrich v. Commissioner (1982)

In 1972, the Diedrichs gifted their three children shares of stock on the condition the kids paid the gift tax. The 8th Circuit held that the donors realized income.

The children’s payment of the gift tax was essentially the sales price of the stock.HOLDING

Affirmed. The payment of the gift tax was income.

H. ILLEGAL INCOME


Illegal Income Gilbert v. Commissioner (1983)

Gilbert was the president and principal stockholder of E.L. Bruce Company, Inc. 1961-62: he borrowed money to acquire stock in the company Celotext Corp. in order to bring about a merger. This merger would have been in both Bruce's and Gilbert's

In general, embezzlers have to pay tax on embezzled funds and cannot use mandated repayments as NOLs.

HOLDINGReversed. When a taxpayer withdraws funds which he fully intends to pay,

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and when he believes these withdrawals would be approved, and then makes a prompt assignment of assets sufficient to secure the amount owed, this is not income.

interest. 1962: the stock market declined, and Gilbert needed to furnish move funds for the stock he had purchased. Lacking the money he withdrew approximately $2mil from Bruce's accounts. He testified he always intended to return it: indeed he informed several officers and directors of the withdrawals. He executed interest-bearing promissory notes to Bruce, secured by his property, to repay the money. The Board accepted the note, but refused to ratify the unauthorized withdrawals. Gilbert resigned. The IRS filed a tax lie on Gilbert for $1.72mil. Thus, Bruce couldn't recover its money from the promissory note and claimed the money as a loss. Gilbert pled guilty to federal and state charges for having unlawfully withdrawn the money. The Tax Court determined that Gilbert had realized income when he withdrew the funds and his attempt at restitution did not offset this income.

I. INTEREST ON STATE AND LOCAL BONDS Yinville and Mahoney bonds example eventually have an equilibrium in rates of

return post-tax (“putative tax”) yield on investment: total economic return on investment on an annual basis federal government is subsidizing localities, so arbitrage bonds seen as an abuse of this

system §148(a) arbitrage bonds:

o expansive definition in statuteo but Treas. Reg. §1.481-2 contains a de minims exception that allows some wiggle

room for this definition

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J. SECTION 121 : GAIN ON THE SALE OF A HOME tax favourable benefits for homeowners:

o imputed incomeo mortgage interest deductiono exclusion of home sale income under §121

§121 allows an exclusion of $250k (or $500k for married couples) limits

o frequency: 1 exclusion/2 yearso limit for nonqualified use (exclusion prorated)

IV. Problems of Timing

A. GAINS AND LOSSES FROM INVESTMENT IN PROPERTY


Realization & Recognition of Gain & Loss From Property

Eisner v. Macomber (1920)

Macomber owned 2200 shares in Standard Oil. Each share had a "par value" of $100. Standard Oil issued a new share for every two shares owned by a stockholder. Thus, Macomber received 1100 new shares. The FMV of the shares fell 30%, so Macomber's wealth hadn't changed. But the government wanted to tax Macomber on the par value of the new shares, which meant her liability would be about $20,000.

The Court’s reasoning in Macomber and its definition of income later repudiated by Helvering v. Bruun and Glenshaw Glass respectively.

HOLDINGThis is not income and therefore cannot be taxed.


Helvering v. Bruun (1940)

1915: TP leased land with a building on it for 99 years. 1929: tenant demolished the existing building and built a new one. 1933: the lease was cancelled because tenant defaulted in payment of rent and taxes. The original building had a value of approx. $13k in 1929. In 1933, the new building had a FMV of approx $64k. The

The Court limited its severable-income reasoning from Macomber. This decision doesn’t match economic reality, and in 1942, Congress passed §§109 and 1019 to postpone recognition of improvement on leased land.

HOLDINGReversed. The TP realized gain in 1933.

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CIR said TP had a net gain of approx $51k. The Tax Court found for TP and Circuit Court affirmed.


Woodsam Associates, Inc. v. Commissioner (1952)

1922: Mrs. Wood bought a piece of property for $296,400, partly finaced by a recourse mortgage. 1931: Mrs. Wood borrowed an additional $75k and consolidated the mortgages for a $400k nonrecourse mortgage. 1934: Wood and his wife organized the petitioner and transferred to it property in exchange for one-half of its stocks. 1943: petitioner paid its income with gains realized upon the mortgage foreclosure sale of this piece of land. It filed a refund on the ground that its adjusted basis for the property had been less than reported. The CIR assessed a deficiency and this was affirmed by the Tax Court.

Although the factors for recognition pointed towards recognition, the court held that nonrecourse borrowing in excess of basis isn’t a taxable event.

HOLDINGAffirmed. The various borrowings did not change the basis for the computation of gain or loss.


Cottage Savings Assoc. v. Commissioner (1991)

P is a savings and loan association regulated by the Federal Home Loan Bank Board. It held numerous long-term, low-interest mortgages that declined in value when interest rats surged in the late 1970s. It would have benefited from selling these loans in order to realize tax-deductible losses. But FHLBB accounting regulations would have required them to record these losses on their books and would have pushed them near to insolvency. FHLBB issued Memorandum R-49 that allowed S&L's to not report

The Court adopted a formulistic approach for determining when property is “materially different:” it looks at whether the properties give rise to different legal entitlements or not.

HOLDINGReversed. The P realized losses at the point of exchange. These losses fit within the meaning of §165(a).

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losses if they swapped mortgages with substantially identical mortgages from other lenders. P did so, trading mortgages worthy at FMV $4.5mil, but with a face value of $6.9mil. P then claimed a reduction of $2.5mil on its tax return. CIR did not recognize this loss. The Tax Court said this deduction was permissible. The circuit court reversed and said this deduction was not permissible.

B. STATUTORY NONRECOGNITION PROVISIONS

1. Section 1031 : Like-Kind Exchanges disposition of property then gain or loss realized (§1001) generally realized gain is recognized (§10001(c)) but not if a non-recognition provisions applies, such as §1031 black letter law:

o No recognition on exchange of LK properties if both for use in ToB/investmento Gain realized = AR – AB. §1001(a).o AR = cash + FMV property received + amount of liabilities discharged. See

1.1001-2(a).o AB = adjusted basis in property exchanged o Gain recognized: to the extent of boot. §1031(b). Assumption of debt by the other

party is boot. 1.1031(b)-1(c). o Basis in new LK property = basis in transferred LK property + net cash paid + net

liabilities assumed + basis in boot property transferred – FMV boot property received + gain recognized – loss recognized

this provision is valuable to real estate market and pushes capital there §1031 is a partial fix to the “lock-in problem” discharge of liabilities included in amount realized (unless buyer cancels debt, then that is

COD income) if both parties had liabilities, offset liabilities in determination of boot (§1.1031(b)-1(c))

2. Basis a tax accounting concept we use to measure income if we want to tax H-S income:

o we would have to keep track of Co take “snapshots” of change in Wealth at end of each year

instead , we look at flows of income in and expenses out

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if income is to reflect ability-to-pay, we need to subtract from gross income the costs of earning that income

thus, question is whether we allow T to subtract that cost now or later if later, then we need to keep track of those deducted costs: this is basis

basis allows T to take “deduction” from expense of buying land at a later date (either through depreciations or from disposition of land)

if you take a deduction for an expense, you can’t include it in basis thus if take a depreciation deduction, then reduce basis

connection between T’s basis and whether T bough property with pre-tax or after-tax dollars:

o if pre-tax dollars, then get no basis in propertyo if pay with after-tax dollars, then T has a basis

C. SECTION 1259 : CONSTRUCTIVE SALES converse situation of Cottage Savings: want to dispose of an investment, but don’t want

to recognize gain lots of tax planning to avoid recognition of gain §1259 treats some transactions that divest taxpayer of the economic risk of an investment

without actually selling the investment as a constructive sales (ex. short sales)

D. SECTION 1273 : ORIGINAL ISSUE DISCOUNT a potential asymmetry in taxation comes from borrowing between taxpayers using

different accounting methods OID rules put cash method taxpayer on accrual method for OID OID = “hidden interest” on a debt instrument cash method debt holder and accrual method debt issuer timing mismatch OID rules puts cash method taxpayers on accrual method: debt holder needs to include in

income yield on debt, which includes stated interest and OID terminology

o issuer of debt instrument = borrowero holder of debt instrument = lendero stated redemption price at maturity (SRPM) = all payments on debt instrument

other than stated interest payments made (at least) annually at a single fixed rate o issue price = what is paid for the debt instrumento applicable federal rate = feds guess at hidden interest

§1272: current inclusion of OID §1273: determination of OID

o §1273(a): OID = excess of SRPM – issue priceo §1273(b): SRPM = all payments other than qualified state interesto §1.1273-1(c)(1)(i): qualified stated interest = stated interest that is unconditionally

payable at least annually at a single fixed rate §1273(b) and §1274: issue price

o if paid cash, then issue price is purchase price (§1273(b))o if bond issuer default, then can deduct loss, but that’s the risko if paid in property (§1273(b)):

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if market for bond, then FMV of bond if market for property, then FMV of property if no market, then discount all payments using the applicable federal rate

to PV and then add them all up (§1274) [see spreadsheet for example of OID: won’t have to do an OID problem on the exam]

F. OPEN TRANSACTIONS AND INSTALLMENT SALES

1. Section 453 : Installment Sales §453(c): ratio used to quantify how much of each payment is income and how much is

recovery of basis purpose of this section is to defer tax liability until T has cash to pay similar to way you pay tax on annuities terminology

o installment sale means a property disposition where payment(s) are to be received in a taxable year following the year of the disposition

o selling price means the gross selling priceo contract price means the net selling price (including the amount, if any, by which

debt exceeds basis)o selling price - adjusted basis = gross profito gross profit / contract price = gross profit ratioo each payment received x gross profit ratio = includible income

Installment Method: Four Step Process5. calculate selling price and contract price

a. selling price is equivalent to amount realizedb. contract price is the amount of cash payments receivedc. will be the same unless property subject to debt

6. calculate gross profit: selling price – adjusted basis7. calculate gross profit ratio: gross profit/contract price8. calculate gain on payments


Open Transactions and Installment Sales

Burnet v. Logan (1931)

T owned 1000 shares of stock in Andrews and Hitchcock Mining Company with a basis of $180k. 1916: Youngstown bought all the shares of Andrews & Hitchcock for a cash payment and additional future payments based on the amount of ore that it would receive from A&H's rights in the iron mine. It was uncertain what these future

The installment sales method is a mix between Logan’s position (open transaction, basis first) and the CIR’s position (closed transaction).

HOLDINGThe Court found for T and held that when the value of future payments are uncertain, the gain is not recognized until the payments actually received exceed basis.

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payments would be. T received a cash payment of $120k.

G. CONSTRUCTIVE RECEIPT AND RELATED DOCTRINES

1. Basic Principles: Constructive Receipt and Economic Benefit cash method taxpayers report income on receipt of each or:

o constructive receipt: about scenario of money just sitting there ready to be withdrawn and

taxpayer is just choosing not to grab it (§1.451-2(a)) positive example in §1.451-2(b) but see Amend

o cash equivalence if promise to pay is transferable then cash equivalent “if a promise to pay of a solvent obligor is unconditional and assignable,

not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is the equivalent of cash and taxable in like manner as cash would have been taxable had it been received by the taxpayer rather than the obligation.” Cowden v. Comm’r

tempered by §453o economic benefit

money just waiting for passage of time (secure from creditors, etc.) see §83 and Pulsifer must be indefinable property and taxpayer’s rights to property must have

vested Taxes receipt of “property” conferring a present economic benefit. Not

necessary for T’s interest to be assignable or for T to be entitled to immediate possession. Must be identifiable “property” and for T’s rights to property to have vested.

a mere promise to pay general not treated as received incomeo administrative concessiono cash equivalence and economic benefit are exceptions

2. Deferred Compensation qualified DC: allow T to defer compensation under specific statutory provisions (ex.

401k)o amount of compensation is usually limitedo restrictions on withdrawals and/or use of money

nonqualified DC don’t have blessing of a specific statutory ruleo threading needle between rules risko no restrictions on withdrawal, amount deferred, etc.

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about time value of moneyo T increases wealth todayo pays tax later, so PV of tax liability is lower

3. Stock Options and Other Restricted Property compensatory stock options: align employee’s incentives with corporation’s incentives noncompensatory options: Code takes open transaction approach wait and see compensatory options: three possible tax treatments

2000$100 strike$120 FMV

2005$100 strike$145 FMV

2010sale for $160

income on receipt (nonst. options, §83)

$20 ordinary $160 - $120 basis = $40 cap. gain

income on exercise (other nonst. options)

$145-$100 = $45 ordinary

$160 - $145 = $15 cap. gain

income on stoke sale (incentive options, §422)

$160 - $100 = $60 cap. gain

(1): this is treatment for non-statutory options if not transferable or subject to substantial risk of forfeiture (§83)

(2): treatment for other non-statutory options (3): treatment of incentive options (§422) most favourable to T

o treatments (1) and (3) are the same if value of option on day option granted is $0 aggressive position for taxpayer to take

a. Section 422 : Incentive Stock Options §422 applies to incentive stock options (ISOs) and applies the approach of gain

recognized upon sale of stock in certain situations The employee must retain the stock for at least two years after the grant of the option and

one year after receiving the stock under the option The option price must be no less than the FMV of the stock at the time of the option is

granted The option must be granted pursuant to a plan that the stockholders know about There is a $100k ceiling on the value of the stock that the ISO can cover: this is

determined by the value of the stock at the time the option is granted §422 is an effectively elective statute, because if the requirements are deliberately not

met, then it won't apply The motivation behind this provision was to give corporations a way to attract new

management and persuade them to stay

b. Section 83 : Nonstatutory Stock Options §83(a): basic rule

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o transfers of property in exchange for services give rise to income to the person who performed the services

o IOUs not secured are not propertyo amount: excess of FMV – amount paid = “bargain element”o timing: on “vesting” = which is earlier of

transferable OR not subject to a substantial risk of forfeiture

§83(b): electiono T can elect to take bargain element into income before vestingo might choose to do this if expect stock price to rise significantly

§83(h): timing of deductiono deduction allowed to payor (usually employer) in the year the bargain element is

taken into incomeo reduces potential revenue loss to Treasury

§83(e): exceptions


Constructive Receipt

Amend v. Commissioner (1949)

T sold his wheat from the 1944 crop to a third-party and shipped the wheat during August 1944. The third-party then paid for the wheat in January 1945, as per the contract. This type of delayed payment was unusual for the industry

Even if buyer was willing to pay earlier, if the timing of the payment is set in the contract, then constructive receipt does not apply.

HOLDINGThe doctrine of constructive receipt did not apply and the petitioner had income in the year in which he actually received the money.

Economic Benefit Pulsifer v. Commissioner (1975)

1969: The petitioners and their father bought a sweepstakes ticket for a race in Ireland. They won. Mr. Pulsifer received 1/4 of the winnings, but the remaining 3/4 was put in a trust for the three minor children and would not be released until the children were 21 or until application on their behalf was made by an appropriate party to the Irish court for release of the funds. Mr. Pulsifer petitioned for release of the funds and he has the

Under the economic benefit theory, a cash-method taxpayer must include any economic or financial benefit they have derived from the absolute right to income from a fund which has been put in trust and cannot be reached by their creditors.

HOLDINGThis was income in 1969 because the economic benefit doctrine applies. This was income in 1969 because the economic benefit doctrine applies

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right to obtain them.Nonqualified Deferred Compensation

Minor v. United States (1931)

1967: Minor's employer, Snohomish Physicians, offered a deferred compensation plan. Under the plan, the physician could elect a percentage of fees to receive and a percentage to be put in a deferred compensation fund. Minor agreed that he would be paid 50% of the fees until 1971, and 10% thereafter. Snohomish created a trust, with three physicians, including Minor, as the trustees. Snohomish was the beneficiary. The trustees invested the trust money into annuities. The money would be payable to the physician or to his beneficiaries upon retirement, death, or disability, or departure from the practice subject to certain limitations. On his 1970-73 tax returns, Minor included only 10% of the fees as income.

Constructive receipt doctrine: income is included in the year in which it was constructively received.

Economic benefit doctrine: an employer's promise to pay in the future is capable of valuation, is nonforfeitable, fully vested in the employee, and secured against the employer's creditors in a trust arrangement, then this is income in the year in which the promise was made.

CIR only argued economic benefit, and since trust not secure from creditors, this argument failed.

HOLDINGAffirmed. Although this plan is at the outer limits of a non-qualified deferred compensation plan, it is nontaxable.

Qualified Deferred Compensation

Cramer v. Commissioner (1995)

TPs all received various numbers of stock options in 1978-1981 from IMED. For some of these options, they elected to file §83(b) elections, claiming zero value for the options. During this time, the TPs received professional tax advice that these options didn't qualify for this tax treatment. In 1982, Warner-Lambert Corp. bought out IMED and paid TPs for their options. Again, the TPs were informed they had a plausible argument that

§83 didn't apply because the options didn’t have a readily ascertainable FMV, and therefore these options' sale produced ordinary income and not capital gains.

HOLDINGAffirmed. §83 didn't apply and therefore these options' sale produced ordinary income and not capital gains. The penalty under §6652(a) was not clearly erroneously applied. The penalty under §6661(a) was

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affirmed. the gain on the options was capital gain, although Treasury regulations probably would hold otherwise. All TPs chose to declare this stock as capital gain, and the Cramers' and Monahans' tax returns included a misreported basis. The IRS assessed a deficiency as well as penalties for intentional disregard of rules and substantial understatement. The Tax Court upheld this decision.

H. TRANSFERS INCIDENT TO MARRIAGE AND DIVORCE divorce or transfer of property on divorce

o realization question depends on state law (community vs. common) division: no realization transfer: realization

o but doesn’t matter in the endo non-recognition under §1041 (post-dates Davis)

alimony and separate maintenanceo typically payee is in a lower tax bracket than payoro if parties structure cash payments as alimony, then benefits parties (because

deduction is worth more than inclusion)o payor deducts (§215)o recipient includes (§71)o technical conditions (§71(b))

child support: no deduction or inclusion tax planning concerns

o incentives to make lump sum or a few large paymentso but rules don’t allow this (§71(f))o hard to separate out alimony and child support payments

alimony v property settlement (§71(g), excess frontloading rules) alimony v. child support (§§71(c), 1.71-T(c))


Transfers Incident to Marriage and Divorce

United States v. Davis (1962)

In 1954, T and his then wife made a voluntary property settlement upon their separation. Under DE law, a wife had certain property

§1041 overruled Davis for recognition of income.

But, Davis is still HOLDING

The

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Commissioner’s assessment of a taxable gain based on the value of the stock on the date of its transfer is correct.

rights, and ex-Mrs. Davis agreed to take 1000 shares of duPont stock and give up any rights she had in Mr. Davis' stock. The various courts had disagreed about whether this was a taxable event. In this case, the court ruled that although it might be a taxable event, there was no way to determine the FMV of the wife's marital rights she traded in exchange for the stock.

good law for the proposition that consideration given = consideration received.

Transfers Incident to Marriage and Divorce

Farid-Es-Sultaneh v. Commissioner (1947)

T received $800k in shares from her future husband. They entered into a antenuptial agreement in which she acknowledged receipt of the shares as a gift and released Mr. Kresge from all her other rights. They were married in 1924 and divorced in 1928. T did not claim or receive alimony. Mr. Kresge's basis in the shares was about 15¢ per share and their value was $10 per share. 1938: T sold the some of the shares for $19 per share. The CIR determined a deficiency for the year 1938 because it said that since the stock was a gift, T had inherited the donor's basis under §1015(a). The Tax Court held that this was a correct application of the statute.

§1041 overruled Farid-Es-Sultaneh.

I. CASH RECEIPTS AND PAYMENTS OF ACCRUAL-METHOD TAXPAYERS

1. Accrual Accounting of Income income recognized when: (§451)

o all the events have occurred which fix the right to receive such incomeo the amount thereof can be determined with reasonable accuracy

method used by taxpayers okay if: (§1.446-1(c)(1)(ii)(C))

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o consistently usedo clearly reflects income and complies with the Regso consistent with generally accepted accounting principals (tax law & GAAP don’t

always match up) industry custom is relevant

2. Uncertain Collections case law has added to the requirements in §451 even if entitlement to income is fixed and amount determined with reasonable accuracy,

income doesn’t accrue if:o substantial doubts about collectability ORo right to income is disputed

doubts must be substantial and not merely technical as soon as sufficiently certain, have to include full amount in come

legal uncertainty about resolution of dispute is sufficient to preclude current accrual

3. Advance Receipt for Goods and Service Automobile Club of Michigan, American Automobile, and Shulde: claim of right and

high threshold for implementing a non “purely artificial” method of accounting for deferral of prepayment recognition until services rendered

o these decisions contrary to GAPP, in which income isn’t included until right to income fixed (T has to perform services)

o but the accrual of membership feeds don’t match individual services provided in AAA cases, so SCOTUS came out this way

IRS changes position, allowing deferral for warranties, subscription income (§455) and membership income (§465)

4. Deposits, Loans, and Trust Funds all events test determines time for including gross income, not whether item is income to

begin with different between if and when questionso if something is incomeo when income is taken into account

amounts place in trust, on deposit, or loans are not income amounts placed in escrow are not income and neither are advance commissions, which

we treat like loans element of choice to withdraw from transaction is important:

o if depositor can demand money back, then not incomeo Indianapolis Power: since customers could withdraw deposits and not forced to

apply to future purchases, then not income

5. Accrual Method: Liabilities liabilities are taken into account when: (§1.461-1(a)(2))

o all events have occurred that establish the fact of the liabilityo the amount of the liability can be determined with reasonable accuracyo economic performance has occurred with respect to the liability

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§461(h): economic performanceo “For purposes of this title, in determining whether an amount has been incurred

with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.”

o when performance occurs: Services and property provided to TP. 461(h)(2)(A).

When services or property are provided to TP When property is used

Service and property provided by TP. As costs in connection with satisfaction of liability are incurred.

Other items Liabilities for workers comp. claims, torts, breach of contract,

rebates, refunds, awards, prizes, jackpots, insurance premiums, warranty and service contract purchases, taxes (other than real property taxes where ratable accrual is elected), anything else not explicitly covered

liability incurred when payment made to the person to whom the liability is owed. 1.461-4(g).


Cash Receipts and Payments of Accrual-Method Taxpayers

Georgia School-Book Depository v. Commissioner (1943)

T was a broker that received an 8% commission on all school books purchased by the State of Georgia through it. In 1938 and 1939, Georgia did not pay the T in full because the Free Textbook Fund didn't have enough money.

All events had occurred which fixed the right to payment, the payment could be reasonably determined, and there was no reasonable doubt Georgia wouldn’t pay T should have included the income.

HOLDINGThe T's commissions on the books should have been included in income in 1938 and 1939.


American Automobile Association v. United States (1961)

T reported as gross income only a portion of the total prepaid annual membership dues it had received or collected in the calendar. This proportion ratably corresponded with the number of membership months covered by those dues and occurring with the same taxable calendar year. The CIR argued that the T

The IRS changed its position from this case and now Rev. Proc. 2004-36 governs.

HOLDINGAffirmed. The T has to include all dues in the year they are paid.

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should have included all the dues in that year.


Westpac Pacific Food v. Commissioner (2006)

1990 and 1991: Westpac made four contracts to buy inventory and receive cash in advance. It received these cash advances conditioned on it purchasing a certain volume. CIR argued that these cash payments were income in 1990 and 19991. The Tax Court agreed.

Westpac had complete dominion over the income, but no undeniable accession to wealth didn’t have income

HOLDINGReversed. There was no accession to wealth, and thus no income, because the T got an increase in cash assets offset by an equal liability for the advance trade discounts.

V. Personal Deductions, Exemptions, and Credits

A. SECTION 165(C): CASUALTY LOSSES Rule

(a) Losses “not compensated for by insurance or otherwise” are deductible(b) Amount of deduction—limited to basis, see Reg. §1.165-7 (lesser of basis or decline in

value)(c) Limitation on losses of individuals:

(1) T/B(2) “for profit” transactions(3) “fire, storm, shipwreck, or other casualty, or from theft”

(h) Treatment of Casualty Gains and LossesThink of it as a co-pay

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Exceeds $100Deduct them to the extent they exceed 10% of gross income + casualty gains

1001 tells you how to calculate a loss; 165 tells you whether this loss is a deduction- Amount realized- adjusted basis= loss- just buying property for personal consumption and sell it for less, then that loss is not

deductibleo example: buy car for $50k and sell it for $20ko not a “true” loss because loss comes from consumption of item


Casualty Losses Dyer v. Commissioner (1961)

1955: The Ts claimed a casualty loss deduction of $100 for damages to a vase. Their cat had a fit and broke one of a matching set, reducing the worth from $250 to $122.49. The vases were insured for $200, but the insurance company wouldn't pay out for the cat-inflicted damaged.

The Court read into the statute a suddenness and unexpected requirement. This was a sudden event, but not unexpected, and therefore not eligible for a casualty loss deduction.

HOLDINGAffirmed. The destruction of ordinary household equipment by a family pet is not a casualty loss.

Casualty Losses Chamales v. Commissioner (2000)

Ts bought a house near OJ Simpson's home. After the murder of Nicole Brown Simpson and Ronald Goldman at the neighbouring home, the area became inundated with media and curious passer-by's. The Ts property value dropped about 20-30% due to this commotion. The Ts had a CPA prepare their tax return. The CPA talked to several real estate agents to determine the loss of value on the home, but told the Ts that he did not think an expert appraisal would be conclusive. The Ts decided to attach an explanation for the casualty loss deduction claimed for the property value loss. The CIR determined a deficiency for the 1994 tax year and

The Ts did not meet the requirements of a casualty loss deduction because:o The event was

not certain.o There was no

property damage (this is a case law requirement in the 9th C).

HOLDINGAffirmed CIR's assessment of a deficiency because Ts' not entitled to a casualty loss deduction.

Reversed. The Ts didn't demonstrate the type of unreasonable or imprudence that would support the imposition of a penalty under §6662(a)

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assessed an accuracy-related penalty.

Casualty Losses Blackman v. Commissioner (1987)

T and his wife were having marital difficulties. While his wife was out, T set some of her clothes on fire on the stove. Subsequently, the entire house burnt down. T was found criminally liable for this act as well; the insurance wouldn’t pay out because loss wasn’t insurable. T deducted as a casualty loss the destruction of his home and its contents. The CIR disallowed the deduction and imposed an accuracy-related penalty.

The result in this case turned on public policy – to what extent should tax policy reinforce other public policy goals?

HOLDINGThe T's conduct was grossly negligent and he is therefore barred from deducting a loss under §165. Allowing a deduction would be against public policy. T should not have an accuracy-related penalty applied against him.

B. SECTION 170 : CHARITABLE CONTRIBUTIONS rule

o –(a) contributions deductibleo –(b) percentage limits

–(b)(1)(A): aggregate can’t exceed 50% of AGI –(b)(1)(B): aggregate can’t exceed 30% of AGI or amount left over from

contributions under –(b)(1)(A) if exceed limits, can carry forward deductions for five years

o –(c) charitable contributions contribution of property with built-in long term capital gain (BIG) property is not a

realization because amount of contribution is FMV (anomaly) but if short-term capital gain or ordinary income, then contribution is basis in property

quid pro quoo personal contribution: deduct the differenceo business contribution: no deduction (Ottawa Silica)

in general, contribution amount not reduced by long term gain but if tangible property unrelated to donee’s purpose, then amount reduced by long term

capital gain (§170(e))


Charitable Deductions

Ottawa Silica, Co. v. United States (1983)

The T owned land near Oceanside, CA. The town wanted to build a school, and

A contribution to a charity is not made for exclusively public

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a good location would be on T's land. T wanted to have access roads to another part of its land, so it agreed to donate the land in anticipation of the access roads being built. It then claimed a deduction of the FMV of the land. The CIR argued the deduction was not allowable. The Claims Court agreed.

purposes if the donor receives or anticipates receiving a substantial benefit in return.

If the corporation receives benefits that are greater than the benefits the general public received from the donation, then this is a quid pro quo transfer and not a deductible charitable donation.

HOLDINGAffirmed. The substantial benefit to T, means that this is not a charitable deduction.

Charitable Deductions

Bob Jones University v. United States (1983)

The IRS denied the petitioners their tax exempt status because the schools practiced racial discrimination in their admissions policies. In Bob Jones, the District Court found for the university and the Fourth Circuit reversed. In Goldsboro, the District Court found for the government, on the basis of Bob Jones.

Is the charitable deduction a subsidy?

?

HOLDINGAffirmed. The IRS was correct to deny the petitioners' their tax-exempt status.

C. SECTION 163 : INTEREST rule

o –(a) interest is deductible when “paid or accrued”o –(h) swallows the general rule basically all interest used to fund personal

consumption is not deductibleo –h(3) qualified resident interest is deductible (mortgage interest deduction)

acquisition debt up to $1mil home equity debt up to $100k

tracingo §163(h)(2)(A): personal interest does not include “interest paid or accrued on

indebtedness properly allocable to a trade or business”o how do you know what debt should be allocated to what?

ex. §265(a)(2) most times, hard to trace and tax planning can be used to obscure these

connections

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D. SECTION 164 : TAXES rule

o taxes listed in §164(a) are deductibleo §164(b)(5): election to deduct sales taxes in lieu of income taxes temporary

rule that gets renewed every year policy

o pros forced exaction

thus not like personal consumption expenditures but Ts get services for taxes, although maybe not proportional to

services received (ex. $2mil homeowner vs. $200k homeowner) diminishes “ability to pay”

o cons leads to oversupply of state and local government services

E. SECTION 151 : PERSONAL AND DEPENDENCY EXEMPTIONS 1987: first year had to include social security number of dependents 7 million

dependents disappeared §151: allowance of deductions for personal exemptions

o –(d)(2): means that can only have an exemption per person if file own return and already claimed as a dependent can’t claim exemption

o –(d)(3): PEPo –(d)(3)(c): if phaseout means exemption is zero, then dependent can’t file own

return and claim personal exemption for themselveso –(d)(4): inflation adjustments

why do we have personal exemptions?o creates a zero-income bracket for people at the bottom ability to payo introduces more progressivityo dependents reduce ability to pay tax system adjusts with family sizeo (also cost to earn income)

VI. Allowances for Mixed Business and Personal Outlays

A. SECTIONS 162 AND 212 : ORDINARY AND NECESSARY EXPENSES §162:

o deduct “ordinary and necessary expenses” incurred in trade and businesso above the line deduction

§212o deduct “ordinary and necessary expenses” for production of incomeo below the line deduction

why is the §162 deduction better than the deduction under §212?

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o §212 only allowable to extent it exceeds 2% of AGI (§67(a)) because misc. itemized deduction

o not everyone itemizes: if take standard deduction, §212 isn’t worth anythingo §212 is also subject to Pease phaseout rules o above the line deductions reduce AGI and so decrease amount of phaseout you

have why is there this distinction?

o theoretically no justificationo §212 deductions are often more dubious because hard to separate out legitimate

business expenses and personal consumption §262(a): no deductions allowed for personal, living, or family expenses

B. CONTROLLING THE ABUSE OF BUSINESS DEDUCTIONS

1. Section 183: Hobby Losses –(a) general rule: for individuals and S corp, if no profit motive, then no deduction –(b) exceptions

o –(b)(1): deductions generally available to individualso –(b)(2) the income from activity (after subtracting the deductions under –(b)(1))

2. Section 280A : Home Offices and Vacation Homes in contrast with squishy §183 test, §280A provides an objective rules-based test

disadvantage with this approach is that test is very complicated –(a) general disallowance of deductions –(b) disallowance applies to §162 and §212 so doesn’t apply to things like mortgage

interest deduction –(c) exceptions where (a) does not apply –(g) deductions disallowed and income excluded for short term rentals

o de minims provision, except a short term rental could produce a lot of incomeo ex. Ty Perrington home improvement show

include home improvement as part of lease payment under §280A(g) could also use §102 or §109


Hobby Losses Nickerson v. Commissioner (1983)

The Nickersons worked in Chicago but decided to secure an alternative form of income for the future. They bought a farm in Wisconsin and began to renovate it. They spent the weekends working on the farm and had a tenant-farmer work the land and convert an addition ten

If have a sincere expectation of profit, then for production of income and not just a hobby. This sincerity is tested on a bunch of factors enumerated in §1.182-2(b)(1)-(9) and is a very squishy

HOLDINGReversed. The farm was clearly a profit-driven scheme and the losses were therefore

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deductible. acres a year to cultivation. In 1976 and 1977 the farm made a loss, but this was expected. The Tax Court found that since profit was not the Ts' primary goal in owning a dairy farm, they could no deduct losses incurred in renovating the farm.

test:1. Manner in which

the T carries on the activity

2. The expertise of the T or his advisors

3. The time and effort expended by the T in carrying on the activity

4. Expectation that assets used in activity may appreciate in value

5. The success of the T in carrying on other similar or dissimilar activities

6. The T's history of income or losses with respect to the activity

7. The amount of occasional profits, if any, which are earned

8. The financial status of the T

9. Elements of personal pleasure or recreation

Home Office Deductions

Popov v. Commissioner (2001)

Katia Popov was a professional musician and used her living room as a practice area. She used the space for four to five hours a day and that was the only thing done in the room. The Popovs claimed a home

§280A(c)(1)(A): a deduction for a home office is allowed if the office is used exclusively as the principal place of business

HOLDINGReversed. The living room was exclusively used as

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Katia's principal place of business and thus the Popovs are entitled to the home office deduction.

office deduction for the living room. The CIR disallowed the deduction and the Popovs filed a petition in the Tax Court. The Tax Court concluded that the home office deduction was not applicable because the office was not Katia's principal place of business, but rather the recording studios and concert halls in which Katia player were.

Commissioner v. Soliman (1993): SCOTUS said that there were two primary considerations for determining whether something was a PPB:1. The important of

the activities performed at each business location

2. The time spent at each place

Hobby Office Deductions

Moller v. United States (1983)

The Mollers derived most of their income from their investments. In 1976 and 1977, they worked full time on their investments. They had a home office in both their summer and winter house. In those years they claimed the home office deduction for both offices. The CIR disallowed the deduction. The Mollers paid the deficiencies and filed claims for refunds. These claims were disallowed and they went to the Claims Court. The court found that the Mollers were investors, not traders, but still allowed them to deduct their home office expenses.

In order to be entitled to a home office deduction, must use office in trade or business (and not just in production of income)

HOLDINGReversed. The T's were investors, not traders, and therefore not entitled to a deduction for a home office used exclusively as a principal place of business for a trade or business.

Office Decorations

Henderson v. Commissioner (1983)

Mrs. Henderson was employed by SC as an assistant AG. She had a furnished office provided by the State. In 1977, T bought a framed print and live plant to decorate her office. She also rented out a parking space across from the office. The T

HAYASHI: this is just a fun case.

For sole proprietors, there is more of a thin line between personal and business expenses for furnishings.

HOLDINGThese are not deductible business expenses, but rather nondeductible

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personal expenses governed by §262.

deducted these expenses, and the CIR disallowed this deduction.

C. SECTION 274: TRAVEL AND ENTERTAINMENT EXPENSES usual rule is an all or nothing classification: EITHER

o personal (§262)OR

o T/B related (§162) §274: specific rule for entertainment, amusement, and recreation

o includes activities covered by §§162 and 212o §274(n): 50% limit on meals and entertainmento §274(m)(3): no deduction for spouse unless certain conditions satisfied

addressing issue in Rudolph §132(d): working condition fringe

o excluded from income if (counterfactually) would have been deductible if T had paid for it himself

o from employer’s perspective, either deductible as business expense or salary


Travel and Entertainment Expenses

Rudolph v. United States (1962)

Mr. Rudolph was employed by an insurance company. His employer provided a trip for its agents and their wives to NYC. The trip was part conference and part sightseeing. The CIR said this was taxable income. The District Court said that the primary purpose of the trip was compensation and the Court of Appeals affirmed.

This case is like Benaglia.

In general, CIR accepts these kinds of trips as excludable under §132 if recreation activities follow bona fide business activities.

HOLDINGCert denied. These expenses were deductible.

Travel and Entertainment Expenses: Business Lunches

Moss v. Commissioner (1985)

Mr. Moss was a partner in a small law firm. The members of the law firm met for lunch every day and discussed their cases. The Mosses included $1000/year for two years as a business expense of these lunches. The Tax Court disallowed the deductions.

The reasoning of this case is thin, but it seems like having a business lunch every single day was just too many.

HOLDINGAffirmed. These lunches were not deductible.

D. SECTIONS 21 AND 129: CHILD-CARE EXPENSES §21

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o $3000/$6000 capo 35% of “employment related expenses,” phased down to 20% as income rises

above $15k §129

o $5000 exclusion under dependent care assistance programso limited by §21o phaseout

both have earned income limitations


Childcare Expenses

Smith v. Commissioner (1940)

CIR assessed a deficiency in the T's 1937 income due to the disallowance of a deduction claimed by the Ts. The Ts had deducted the amount the had spent on child care so that the wife could work

This is still good law: childcare expenses are not deductible under either §§162 or 212. But they are governed by §§21 and 129.

HOLDINGThis is a living expense and not a business expenses and therefore not deductible.

E. COMMUTING EXPENSES if you pick a place to live and then look for a job that requires commuting

o at first glance, this looks like a deductible expenses under §162o in H-S terms, this also looks deductible

but if you have a job and then look for a home and choose on that requires commuting this now looks like a personal expenses

there is no obvious answer to this question because first principles don’t yield an intuitive answer


Commuting Expenses

Commissioner v. Flowers (1945)

Flowers was a lawyer who lived in Jackson. He got a new job in Mobile, and he commuted between the two. In 1939 and 1940, he deducted the expenses of travelling between the two cities, as well as his room and board in Mobile, as business expense deductions. The Tax Court found that the T was not entitled to these deductions. The Court of

There are three conditions that must be satisfied in order to deduct a traveling expense: (p439)1. "The expense

must be a reasonable and necessary traveling expense, as that term is generally

HOLDINGReversed. These were not deductible expenses.

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Appeals reversed. understood."2. "The expense

must be incurred 'while away from home.'"

3. "The expense must be incurred in pursuit of business."

Commuting Expenses

Hantzis v. Commissioner (1981)

Mrs. Hantzis was a student at HLS. She got a summer job in NYC for ten weeks. Her husband remained in Boston working and she got an apartment in NYC for the summer. They deduced the cost of transportation between Boston and NY, as well as her lodging and meals, on her tax return. The CIR disallowed the deduction on the grounds that these expenses were not incurred while away from home or in the pursuit of a trade or business under §162. The Tax Court rejected both these arguments and allowed the deduction.

Can only claim travel expenses if “away from home.” Court interpreted “home” as principal place of work, and not a personal concept of home.

HOLDINGReversed. T was not away from home and therefore these expenses are not deductible.

F. CLOTHING, LEGAL, AND EDUCATION EXPENSES


Clothing Expenses

Pevsner v. Commissioner (1980)

Mrs. Pevsner worked for a YSL boutique and was required to wear the brand's clothes at work. She wouldn't have bought them except for her job requirement, and didn't wear them outside of work. She deducted the costs of the clothes. The CIR disallowed the deduction. The Tax Court allowed the

Objective test: clothes are deductible as a business expenses if (p453)1. The clothing is

of a type specifically required as a condition of employment

2. It is not

HOLDINGReversed. Deduction is disallowed

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deduction, holding that the apparel was not suitable to the private lifestyle of the T.

adaptable to general usage as ordinary clothing

3. It is not so worn

Legal Expenses Untied States v. Gilmore (1963)

Gilmore and his wife were involved in a messy divorce. Part of the divorce involved a fight over Gilmore's controlling stock in three corporations. Gilmore won the legal battle and deducted his legal costs as a business expense. The CIR disallowed the deduction. The Court of Claims allowed 80% of the deduction for the costs spent defending the stockholdings as an expenses under §212.

Origin of the claim doctrine: legal expenses are only deductible as business expenses, if the legal claim arose out of business dispute (and not a personal dispute).

HOLDINGReversed. The expenses are not deductible.

Educational Expenses

Carroll v. Commissioner (1969)

T had deducted the cost of some college courses he had taken (they would make him eligible to apply to law school). He was a policeman and his department had allowed cops to rearrange their schedules so they could take classes.

§1.162-5 greatly limits what educational expenses you can deduct.

HOLDINGThese college courses are not deductible.

VII. Deductions for the Costs of Earning Income

A. CURRENT EXPENSES VERSUS CAPITAL EXPENDITURES

1. Capitalization Theory timing: should expenses by capitalized (and added to basis) or deducted now? whether an expenditure is currently deductible or capitalized depends on whether money

is used to buy long-lived asset all expenses are eventually deductible either:

o when madeo over time (depreciation/amortization)o when property is sold (deduced from amount realized)

questions to asko Q1: what is deductible or capitalized?

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o Q2: if capitalized what, if any, depreciation or amortization (amortization = depreciation for intangible property)?

2. Section 263A : Uniform Capitalization Rules –(a)(1): certain costs of property to which §263A applies are included in inventory or

capitalized can’t capitalize costs that wouldn’t be deducible (ex. personal expenses) –(a)(2): what these certain costs excluded are advertising/marketing and some

administrative costs –(b)(2): what kind of property this applies to

o –(1) real or tangible propertyo –(2) property acquired for resaleo –(2)(b) exception: this section doesn’t apply to T whose gross receipts are less

than $10mil concession to the fact that these are complicated rules –(h): free lance authors, photographers, and artists are also excluded from this section INDOPCO regulations cover intangible property [we’re not covering them in this class]


Current Expenses vs. Capital Expenditures

Encyclopaedia Britannica v. Commissioner (1982)

T treated its advances to a third-party who was writing the manuscript for a Dictionary of Natural Sciences as ordinary and necessary business expenses deductible in the years in which they were paid, even though they had not yet received royalties. The CIR disallowed the deductions. The Tax Court found for the T.

If an asset will produce an income stream into the future, then it should be capitalized.

Since this case, §263A requires the cost of producing inventory and other self-created assets to be capitalized (thus fixing the distortion between in house and subcontracted production created in this case).

HOLDINGReversed and remanded. This is a capital expenditure. Tax Court should determine whether these are research and experimental expenditures under §174 on remand.

B. REPAIR AND MAINTENANCE EXPENSES

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o repairs that are periodic and small, or are caused by unexpected events, are more likely to be deductible

o when cause and extent conflict, extent tends to be the determinative factor capitalization of small expenses is administratively burdensome the depreciation allowance covers the loss in value due to the passage of time courts

generally don’t allow repair deductions for passage of time casualty loss and repair loss

o both are subject to actual economic loss (i.e. insurance treated the same way)o can only claim one deduction for one losso repair losses can cover expense not covered by casualty


Repair and Maintenance Expenses

Midland Empire Packing Co. v. Commissioner (1950)

T had used its basement to cure meat for 25 years. Water had seeped into the basement, but it had drained out. In the taxable year at issue, oil from a nearby refinery was seeping into the basement and couldn't escape. This was causing a fire hazard and the federal meat inspectors told the T they must oil-proof the

The case law on whether something is classified as a repair or an improvement is muddy:o repairs that are

periodic and small, or are caused by unexpected events, are more likely to be

HOLDINGThese expenses are deductible under §162.

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basement or shut down the plant. The T oil-proofed the basement and deducted the cost as a repair. The CIR said that it was a capital expenditure.

deductibleo when cause and

extent conflict, extent tends to be the determinative factor

C. SECTION 471 : INVENTORY ACCOUNTING manufacturer can’t deduct costs of inventory until sold: match costs and revenue §1.61-3: defines GI for inventory as total sales – cost of goods sold costs of inventory are essentially capitalized COGS = opening inventory + purchases = closing inventory don’t need to take separate deductions for losses in inventory issues

o identifying which goods are included in inventory and wheno determining costs of inventoryo allocating opening inventory/purchases to sales and closing inventoryo applying lower of cost or market valuation ruleso applying mark-to-market rules for certain taxpayers

D. “ORDINARY AND NECESSARY”

1. Section 162 : “Ordinary and Necessary” Requirement answer has never been very clear does work to distinguish personal vs. business and deductible vs. capitalized

2. Reasonable Compensation §162(a)(1): can deduct salaries of employees can’t deduct dividends, so companies incentivized to pay shareholder-employees with

salary rather than divides §162(m) puts limits on salary to try and get to reasonableness

o huge holes in thiso incentives companies to make most of compensation performance-based (because

not subject to these limits)


“Ordinary and Necessary” Expenses

Welch v. Helvering (1933)

Welch Corp had gone bankrupt. T made a contract afterwards with another company to purchase grain for it on a commission. In order to re-establish his relations with customers

The courts use “ordinary and necessary” to distinguish between business/personal and deductible/capitalized.

HOLDINGAffirmed. These are capital expenditures.

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whom he had known when working for Welch Corp, he paid off the debts of the business as far as he was able to. The CIR ruled that these were capital expenditures to develop reputation and goodwill, and not deductible. The Tax Court and Eighth Circuit affirmed.

“necessary” = appropriate and helpful

“ordinary” =/= frequent for that T, but something like normal, expected, not bizarre within T/B

“Ordinary and Necessary” Expenses

Gilliam v. Commissioner (1986)

Mr. Gilliam was an artist who was travelling to Memphis to fulfil a business obligation. He had a history of mental illness. On the flight to Memphis, Gilliam attacked a fellow passenger and seriously injured him. Gilliam was charged with a variety of crimes and was acquitted by reason of temporary insanity. Gilliam deduced his legal fees and the settlement he paid in the civil suit under §162. CIR disallowed these expenses.

These expenses were not caused by T’s business trip and so aren’t deductible (this is the way HAYASHI thinks about it, and not really the way the court did).

HOLDINGThese are not deductible expenses under §162.

E. DEPRECIATION two questions to ask when faced with a business expenses:

o deduct or capitalize?o if capitalized, what, if any, depreciation (tangible) or amortization (intangible)?

if depreciates, then it is a “wasting asset”

1. Straight Line Depreciation straight line: take same dollar value in depreciation each year under §168, certain kinds of property are depreciated under this method

2. Accelerated Depreciation: 150% and 200% method:6. Calculate % of property’s basis depreciated in year 1 under the straight line method. 7. Multiply that percentage by 2 or 1.5. Call this new percentage X%. 8. Every year, calculate the depreciation deduction that would be taken if the property were

depreciated on a straight line basis over its remaining useful life treating it like property acquired new and placed into service that year (for each year of useful life)

9. Depreciate in that year at the greater of the number in (3) or X% of the basis.

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10. Reduce the property’s basis for the depreciation. 200% example:

3. Sections 167 & 168 : Depreciation §167

o –(a): allows the deduction for certain types of propertyo –(b): basis = AB from §1011 higher basis means a higher depreciation

deduction §168

o –(b): applicable depreciation method –(1): in general use 200% method –(2): when use 150% method –(3): when use straight line method

o –(c): useful life tableo –(d): midyear conventionso –(e): what property fits in each category

in general, these rules don’t reflect economic reality generally can depreciate property faster than actually lose value either a

result of lobbying (handout) or attempt to encourage investment salvage value is usually assumed to be zero

F. THE ALTERNATIVE MINIMUM TAX

1. Computing AMT Liability initially imposed to quell outcry about a few wealth people from $0 in tax liability now applies to far more people, beyond just the wealthy adds a significant compliance burden huge amount of revenue so Congress just temporarily patches it, but doesn’t overhaul it big issue: exemption threshold and rate brackets aren’t indexed to inflation method for calculating AMT liability

1. Taxable income (under regular tax)2. + preferences3. + timing adjustments (ex. depreciation happens more slowly)4. = AMTI

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5. - exemption amount 6. = Taxable excess tax base of AMT7. x AMT rate schedule (26, 28%)8. = Tentative minimum tax9. - Tax (under reg. tax) less certain credits 10. = Alternative minimum tax (pay this in addition to regular tax)

the biggest preference is SALT so Ts in high tax states (ex. CA, NY, MA, NJ, DC) pay more AMT

other big preferences:o personal exemptionso misc. deductionso NOLso incentive stock options

1 . Case Summaries TOPIC AREA CASE NAME KEY FACTS TAKE HOME

AMT Klassen v. Commissioner (1999)

The Klassens had an income of $83,056 and ten dependent children. The submitted a return under a normal calculation, but didn't compute AMT liability. The CIR issued a notice of deficiency and found the Ts liable for an additional $1085.43 AMT. he Tax Court ruled in favor of the CIR.

Although the AMT was originally designed to target wealthy individuals, now it captures those who are not wealthy.

HOLDINGAffirmed. The Klassens are subject to AMT.

VIII.Tax Progressivity and Splitting of Income

A. INCOME FROM SERVICES: DIVERSION BY OPERATION OF CONTRACT OR LAW


Income Splitting Lucas v. Earl (1930)

Mr. and Mrs. Earl agreed to a contract in which half of Mr. Earl's salary was shared as joint tenants with the right of survivorship. Thus, Earl only put down half his income for his tax return in 1920 and 1921. The CIR assessed a deficiency and the Board of Tax Appeals

The Court said that a married couple couldn’t contract an income splitting arrangement.

HOLDINGReversed. Mr. Earl can be taxed on all the money.

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affirmed. The Circuit Court reversed.

Income Splitting Poe v. Seaborn (1930)

The Seaborns owned a large amount of property as community property. Both reported half of the income derived from the community property and deduced half of the expenses. The CIR determined that all of the income should have been reported on the husband's tax return.

The Court distinguished Lucas v. Earl and said that (involuntary) division by state property law was not prohibited.

HOLDINGAffirmed. One half of the income should be reported by each spouse.

B. THE MARRIAGE PENALTY AND BONUS brackets aren’t doubt at the top, so there is a marriage penalty for two-earner couples outcomes not consistent with ability to pay EITC also has marriage penalties consequences is that traditional one-earner couple has a more favourable tax treatment trilemma: can’t have a tax system that:

o has progressive rate structureo taxes couples with the same income equallyo provides no incentives/discentives equally

one solution: adopt a flat taxo eliminates income splitting advantageso reasons we have progressive rates rather than a flat tax

reflects ability to pay better because marginal utility of dollar decreases with more income

tax liabilities should be based on benefits: assuming rich benefit more from government than poor

C. TRANSFERS OF PROPERTY AND INCOME FROM PROPERTY


Income Splitting Blair v. Commissioner (1937)

T had assigned various amounts of interest to his children through trusts. The trustees accepted the assignments and distributed the income directly to the assignees.

Since T has assigned his children a horizontal slice of his property rights (fully vested into perpetuity), then this was income to his children and not to T.

HOLDINGThe assignees were owners of the interest and therefore they, and not the T, are

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taxable on the interest income.

Income Splitting Helvering v. Horst (1940)

T owned negotiable bonds and gave the negotiable interest coupons as a gift to his son. The CIR said that these interest payments were taxable to T.

Since T had given his son a vertical silence of his property rights (temporal limitation and acted as a “carved out interest” with a reversion), then this was income to T.

HOLDINGReversed. This is taxable to the T.

IX. Capital Gains and Losses

A. BACKGROUND AND STATUTORY FRAMEWORK

1. Capital Gains and Losses rationales for the favourable treatment of capital gain

1. bunching if capital gain accrues and realized all in one year, then T pays more than

would if had recognized income every year T could avoid this by selling a bit every year

2. lock-in if T has to pay tax when sells asset, disincentivized from efficient use of

capital §1031 solves the lock-in problem as well lowering the tax rate also solves the problem

3. inflation some of the measured gain is nominal, but not real, because attributable to

inflation capital gains is a rough offset for this inflation but very crude because

no connection between capital gains rate and inflation rate4. general investment incentive

have to consider cut in capital gains with larger impact on fiscal system ex: ordinary income tax will have to increase or spending will have to

decrease in order to balance the budget if lower capital gains5. incentive to new industries

but preferential treatment applies to all capital gains6. unrealized gains untaxed

HAYASHI: this seems to be just a recapitulation of the lock-in problem7. reduce double tax on corporate savings

but preferential treatment applies to all capital gains HAYASHI: lock-in rationale is best rationale because lock-in is inefficient and reducing

capital gains does effectively solve this problem

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these rationales help explain some of the distinctions courts make between capital assets and other property ex: carve out for inventory makes sense because choices about inventory are not that tax sensitive

problem with preferential treatment: people work hard to convert ordinary income into capital gains

this means net effect of lowering capital gains rate is ambiguouso lower rate should mean revenue increaseso but as people move income around, revenue would decreaseo expert analysis hasn’t been able to conclusively show either thing happening

2. Section 1(h): Capital Gains Rate • very complicated procedure for calculating tax on net capital gain = net long term capital

gain – net short term capital loss. • rate depends on taxpayer status and type of property• multiple steps, complex netting across three categories of property in this class we’re

just going to look at the third “bin:” 0%/15%/20% property• net capital gain generally taxable at 15%• some may be taxed at 0% if in the 10% or 15% ordinary income category• starting 2013, 20% rate applicable to extent that taxpayer’s income exceeds the

thresholds for 39.6% ordinary tax rate (e.g., $400,000 for singles) + 3.8% Medicare tax max rate, therefore, is 23.8% rather than 39.6%

• strong incentives to characterize income as capital gain

3. Section 1211: Net Capital Loss • —(a): basketing rule for corporations only allowed to extent of capital gain• —(b): basketing + up to $3000 of ordinary income

• more favourable to individual taxpayer• taxpayers will engage in “loss harvesting” at the end of the year to offset $3000 of

ordinary income (limited by “wash sale” rules: if sell stock at loss, have to wait 30 days before you buy it back trying to prevent taxpayers harvesting loss and then putting themselves back into exact same financial position)

4. Section 1222: Net Capital Gain • —(11): net capital gain = excess of net long term capital gain (7) – net short term

capital loss (6)• —(7): net long term capital gain = excess of long term capital gain – long term

capital loss• —(6): net short term capital loss = excess of short term capital losses – short term

capital gains• —(3): dividing line between short term and long term is one year:

• short term: up to and including a capital asset held for a year• long term: a capital asset held for more than a year

5. Section 1221: Capital Asset • —(a): property held by T except for:

• —(1): inventory not worried about lock-in

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• —(2): depreciable business property and real property for T/B• —(3): certain IP

…• if not a capital asset, gains and losses treated as ordinary income, except if overriding

provision (ex. §1231)

6. Section 1231: Property Uses in a Trade or Business • ordinary loss and capital gain for T/B property (as defined in §1221(a)(2))• favourable treatment: best of both world• similar special treatment for small business stock (§1244)• §1245: gain from certain depreciable property is ordinary to extent of depreciation

matching ordinary deductions to later ordinary gain

B. PROPERTY HELD “PRIMARILY FOR SALE TO CUSTOMERS”


Capital Gains & Losses

Bielfeldt v. Commissioner (2000)

T sought to overturn a Tax Court decision denying him the right to off set trading losses incurred in the 1980s against all but $3000 a year in ordinary income. If he was successful in this claim, he was entitled to a $85mil tax refund.

Taxpayers want capital gains and ordinary losses, so try and manipulate it so income falls into or out of capital gains.

HOLDINGAffirmed. T was a trader and these are capital losses and subject to the restrictions on capital losses.

Capital Gains & Losses

Biedenharn Realty Co. v. United States (1976)

T bought a plantation in 1935 and used it as a farming investment. From 1939 to 1966, three subdivisions were carved out of it. T reported 60% of the gain as ordinary income and 40% as ordinary income. The IRS assessed a deficiency, arguing all gains were ordinary income, and T filed for a refund claiming all the gains were capital.

A simple liquidation of an investment property will be treated as a capital gain/loss, but can start to look like inventory in a dealer’s hands and then income treated as ordinary gain/loss.

HOLDINGReversed. The T's activities are all ordinary income.

X. Tax Compliance and Penalties

A. TAX COMPLIANCE

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federal income tax: self-assessed (not voluntary) returns generally required if gross income > exemptions + standard deduction (§6012) penalties: civil (§6054) and/or criminal (§7203) penalties for underreporting income are less than for not filing at all IRS takes steps to ensure collection:

o before April 15 withholding (§2402) and payments of estimated taxes (§6654) facilitate

collection income from employer on W2 reported to IRS if independent contractor, a copy of 1099 goes to IRS

o after April 15 all tax returns assessed for computational errors audits

assessment is within 3 years of when return was filed (§6501) any underpayment is assessed, with interest, at the rate on short

term US debt plus 3% if you disagree with IRS

o negotiate with IRS and settleo go through administrative processo judicial review

pay and sue for a refund in District Court or Court of Federal Claims don’t pay and go to Tax Court

B. DEFENSES FOR §6662 & §6663 PENALTIES substantial understatement

o “substantial authority” (§6662(d)(2)(B)(i))o “adequate disclosure” of the facts and a “reasonable basis” (§6662(d)(2)(B)(ii))

negligence and substantial understatement: o “reasonable cause” and “good faith” (§6664(c)(1))o hiring a tax lawyer and getting a reasoned opinion can help demonstrate good

faith

C. HOW SURE DO YOU NEED TO BE? “will:” 90% “should:” 70% “more likely than not:” > 50% if tax shelter involved, tax preparer needs to meet this “substantial certainty:” 30-50% “realistic possibility of success:” 33% return preparers breach professional duty if

don’t meet this “reasonable basis:” 15%-30%

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