COMPUTATION OF TAX LIABILITY....................................................

2
WHAT IS INCOME?.........................................................................3

Compensation for Services...................................................................3

Fringe Benefits....................................................................................3
Imputed Income..................................................................................6
Do You Have to Work For Your Income?.................................................7
Capital Appreciation and Recovery of Capital........................................8
Annuities and Life Insurance..............................................................11
Treatment of Debt.............................................................................13
Damages and Sick Pay.......................................................................17
Tax Exempt Interest...........................................................................19
Summary..........................................................................................20

DEDUCTIONS AND CREDITS..........................................................22

WHOSE INCOME?........................................................................50
CAPITAL GAINS AND LOSSES........................................................55

COMPUTATION OF TAX LIABILITY

(Gross Income) (ATL Deductions) = (Adjusted Gross Income)

(AGI) (BTL Deductions) = (Taxable Income)

(Taxable Income) x (Tax Rate) (Tax Credits) = (Tax Liability)
1

Calculate gross income ( 61)

statute lists a non-inclusive list of sources included in gross income.
Includes compensation, fringe benefits, dividends, royalties, annuities, income from insurance,
discharge of indebtedness income, pensions, income from an interest in an estate or trust.
If it is included in gross income, will be found in 61, 71-89 of the code.
Does not include excluded categories which are found in 101-134 of the code

Subtract "above-the-line" deductions ( 62). The resulting figure is known as adjustable gross income
(AGI).
The deductions include:
ordinary and necessary business expenses - 162
reimbursed business expenses - 62(a)
expenses of performing artists - 62(b)
losses from sale or exchange of property - 161 & 62(a)(3)
alimony by payor - 215
Its above the line if in 62. With 162, 212, and 163 it depends.

Subtract "below-the-line" deductions (the sum of personal exemptions, 151) and the larger of either:
standard deduction; or
itemized deductions (start with 63 and 67).
67 affects ONLY miscellaneous itemized deductions -- 2% floor of adjusted gross
income
You only deduct the amount by which your total miscellaneous ID > 2% of
your AGI
Non-Miscellaneous Itemized Deductions - 67(b):
interest - 163; casualty losses -- 165(a); taxes - 164 (state, local, and
property); charitable contributions -- 170, 642(c); medical expenses - 213;
moving expenses - 217; annuity mortality losses - 72(b)(3)
68 3% haircut affects ALL itemized deductions
Reduce your itemized deductions by lesser of:
3% of excess of your AGI above 100K (MFJ, HoH, Single), 50K MFS.
(adjusted for inflation)
OR 80% of all of your itemized deductions otherwise allowable. (you
always get at least 80% of your deductions)
Phased out between 2005 and 2010
Lots of deductions dont get hit 68(c):
Medical expenses under 213; Investment Interest 163(d); Casualty
& theft loss 165
The resulting figure is taxable income.

Apply the tax rate schedules (found in 1) to taxable income to determine tentative tax liability.

Subtract from tentative tax liability any available tax credits. The remaining amount is final tax liability.
Credits include Hope and Lifetime Learning (25A), child care credit (21(a)), disability and old
age ( 22), tax withheld ( 31), and earned income in the case of low-income taxpayers ( 32).

WHAT IS INCOME?
Compensation for Services
Old Colony (U.S. 1929)
If a third party pays your income tax for you, either voluntarily or as a discharge of indebtedness, you have to
include that payment in income.
Examples:
o Er pays Ees rent income
o Er pays $10K to your mom income
o Er pays your property taxes, mortgage, state income tax, etc. income, even though these would have
been deductible anyway
-buto Er pays your hotel bill for a biz trip excluded b/c its a biz expense
o Er makes matching donation to charity not income
Gross Income Defined: gross income means all income from whatever source derived, including. . . [both business
incomesalary, self-employment wages, etc.and capital incomedividends, interest, etc.]
If extra compensation is in the form of property, its still income to the extent of the FMV of the property. Or,
if you purchase property from Er at less than FMV, the difference b/w the price paid and mkt value is
considered to be salary.
When your Er gives you property (e.g., a car), you take it into income and get basis in the property.
If Er gave you a car, it would be income.
o If you sold car the next day for the same price, you wouldnt have to pay tax again b/c you were just taxed
on the FMV of the car. But, if you sell for a profit, youre taxed on your gain.
If Er sells you the car for $15K but its worth $20K, you have income of $5K (difference b/w FMV and what
you paid)
Fringe Benefits
Fringe Benefits Generally

Fringe Benefits: In-kind benefits transferred to an employee; outside core salary and bonus
o Examples:
Health care, gyms, cafeteria on premises, employee discounts
o Can be addl compensation (e.g., all-expenses paid vacation); or can be essential to the performance of
the employees job (e.g., chalk used by teacher)

CODE PROVISIONS
Dependent Care [ 129]: Excludes payments made by an Er for the care of dependents of its Ees. Er will
reimburse Ee.
o Ltd to $5K ($2,500 for married filing separately)
o If Er provides childcare it wont be included in incomenot a biz expense
o Doctrine of Constructive Receipt: if you could have taken the cash and you chose not to, youre taxed as
if you took it
Solution: Cafeteria Plans
Cafeteria Plans [ 125]
o You can get cash or one of a number of nontaxable fringe benefits. Ees are essentially buying the benefit
with their salary but theyre getting it tax-free.

o Excludes Er contributions to nondiscriminatory cafeteria plans (cant be focused on key Ees)

o Constructive Receipt rules do NOT apply to cafeteria plansyou can pick and choose
Educational Assistance Programs [ 127]: Er can provide Ee w/up to $5,250 for educational purposes only
(includes tuition, fees, books). Er must not provide eligible Ees w/a choice b/w edu assistance and other
remuneration or income. Er must actually pay for it.
Transportation Fringe Benefits [ 132(f)]
o Includes qualified parking (i.e., provided to Ee on or near the biz premises), transit passes, and
transportation provided in a commuter highway vehicle that is used principally to drive Ees to and from
work
o $175 for monthly parking/transit pass plus inflation adjustment ($230) is excluded under 132(f)(2).
Shall not exceed means anything that is over $230 will be taxed.
o No constructive receipt
Working Condition Fringe [ 132(d)]
o Non-discrimination rule does not apply to working condn fringe
o Any property or services provided to the Ee of Er to the extent that, if the Ee paid for such property or
services, that payment would be allowable as a deduction under 162 or 167
Qualified Employee Discount [132(c)]
o Merchandise: excluded to the extent that it does not exceed the Ers gross profit percentage; does not
extend to real property or personal property of a kind commonly held for investment
o Services: excluded to the extent it does not exceed 20% of the selling price of the services to non-Ee
customers (no gross profit percentage restriction)
o Airline Ees can fly free under no addl cost service.
o Ees of the hotel are not ok under 132(c): not in the ordinary course of the line of biz of the service.
o Special exception for parents (spouses, children, etc.) of airline Ees to fly free under 132(h)
De Minimis Fringe [ 132(e)]
o Any benefit that is so small that accounting for it is unreasonable
o Operation of any eating facility by Er is de minimis if (1) on or near the premises and (2) revenue derived
from the facility normally equals or exceeds operating costs

Work Related Fringe Benefits

The less control an Ee has over his schedule, the more likely there is to be a biz benefit.
United States v. Gotcher (5th Cir. 1968)
Facts Husband and wife get all-expense paid trip to Germany to tour VW factory, paid for by Er and VW.
Trip was made when VW was attempting to expand its local dealerships in the U.S. Question is
whether the cost of the trip should be included as income. Holding: Ms. Gotchers expenses should be
included in income (not deductible). Mr. Gotchers half was deductible.
Primary purpose of the trip was for Mr. Gotcher to buy a VW franchise
Court focuses on the amount of control Gotcher had over his schedulethe less control, the more it looks
like a biz trip
274(c): now the explicit rule for foreign travelreqd to allocate expenses b/w biz and personal when
trip is outside the U.S.
Meals and Lodging: 119
119: The value of any meals or lodging furnished to Ee, his spouse or any of his dependents by the Er shall
be excludable from gross income if:
At the convenience of the Er
On the premises of the Er (for meals)
Required as a condition of the Er (for lodging)
Meals

Unlike lodging, meals do not have to be a condition of employment.

Optional / non-discrimination provisions are irrelevant here.
Convenience of Er: met when there is a substantial non-compensatory purpose
119(b)(4): If meals are furnished on the biz premises to all Ees and more than half of the Ees to whom those meals
are furnished are for the convenience of the Er, then ALL meals will be treated as provided for the convenience of
the Er.
Kowalski (U.S. 1977)
Facts State trooper argued that a daily meal allowance (cash) (1) fell under 119; or, in the alternative, (2)
falls under the common laws allowance for meals and lodging when for the convenience of the
employer. No requirement/accounting for how the money is spent.
Cash meal allowances are income.
This does not overrule Gotcher. In Gotcher, the IRS says you have to find it within a statutory exception,
but the court here is saying that the exemption doesnt have to be statutorycan look to rulings and case
law.
*Reed thinks that if the troopers had been given vouchers redeemable for a particular place and time, it
would have been tax-free.
Sibla (9th Cir. 1980)
Facts Firefighters were required to eat meals together at the firehouse. Paid for it as a group. Got a fixed
cash advance for food. It was excluded from income.
This is ok under 119(b)(3). Limits Kowalskisays that case was only concerned w/cases over which TP
has complete dominion.
Christey (8th Cir. 1988)
Facts Trooper doesnt make the same argument as in Kowalskiinstead, he wants to deduct the meal
allowances as ordinary and necessary biz expenses under 162.
Court allows troopers to deduct the costs of meals that they were required to eat at public restaurants
adjacent to the highway while theyre on duty.
Lodging
Benaglia (B.T.A. 1937)
Facts Benaglia was the manager of several hotels in Hawaii. He and his wife lived in one of the hotels for
free and ate all of their meals at the hotel for free. Did not report this as income
Not income. Benefits were primarily for the benefit of his Er
Too hard to determine % biz and % personal, so court just says its all biz
Property Transferred for the Performance of Services: 83
83(a): If TP is permitted to purchase property or services at a price below FMV b/c seller is compensating
purchaser for services, the purchaser has gross income in the amount of the discount.

But what if the property is subject to a substantial risk of forfeiture (i.e., right to full enjoyment of the
property is conditioned on future work performed)? [83(c)]
83(a) says: Ignore it until it vests. Once the property vests (and forfeiture risk is removed) TP must include
basis of property in income
o Hypo: You join corp and buy $200K worth of stock for $100K, vesting in 5 years. After it vests, you
sell it for $2.1M. Under 83(a), no inclusion in year 1. But in year 5, income of $2M. At a 35% tax
rate, youll owe $700K.

Basis = [FMV at time of vesting amount paid for the property]

*Note: If you bought stock and the stock pays dividends in the meantime, ownership doesnt transfer until
vesting. Once they vest, they are taxed as ordinary income (b/c compensation)

83(b) Election Provision: TP can elect to take the property into income immediately. If TP does this, then Er takes
deduction for compensation under 162 in the year Ee includes the property in income.

Good deal if you are sure property will vest and you want to pay lower cap gains
Bad deal if you arent sure the property will vest or if you would prefer to minimize the capital gains you pay
later on.
o Hypo: Join company and buy $200K worth of stock for $100K vesting in 5 years. After it vests, sell
for $2.1M. If you make the 83(b) election, include $100K in income in year 1 and owe $35K of tax
(@35% rate). Basis is $200K. In year 5, gain is $1.9, taxed as capital gains.

Interest-Free Loans
General Rule: A loan (at market rate) is not income b/c liability to repay offsets

Below market loan = loan w/0% interest or interest less than the AFR
An interest free loan will be recharacterized to reflect the economic reality of the situation:
o Example [Gift Loan]:
You give your brother $1K loan at 0% interest.
Under 7872, this is how this loan will look:
(1) You lend bro $1K, he promises to pay you back at 10% interest
(2) You are treated as having given your brother $100
(3) Brother is treated as having repaid you $100 of interest
7872 basically says you cant get around tax consequences by dropping interest rate to 0. You, the lender, will
have income in the amount of the foregone interest (i.e., the excess of amount of interest which would have
been payable minus the amount actually payable)

7872(c): Applies to below market loans in the following categories: gift loans, compensation-related loans,
corporation-SH loans, tax avoidance, etc.

Exceptions:
o $10K de minimis exception
Giftsapplies unless the loan is directly attributable to income-producing assets
Compensation-related and corporate-shareholderapplies unless its purpose is tax avoidance
o Limit on interest accrual for gift loans up to $100K [7872(d)]
Amt treated as retransferred from the borrower to the lender shall not exceed the borrowers net
investment income for that year (helps parents make loans to kids for school, down-payments,
startups, etc.)
Net investment income can be from any source
Hypo: I loan bro $100K at 2%. Foregone interest is $3K. Because of this limitation, the amount
retransferred from the borrower to the lender cant exceed the borrowers net investment income.
If bro has $12K of net investment income up to $3K is transferred back
If $2K of net investment income up to $2K is transferred back
If $500 of net investment income nothing is retransferred when net investment income
doesnt exceed $1K

Demand Loans: Any gift or loan payable on demand. A below-market demand loan is one in which the interest
payable on the loan is less than the applicable federal rate
Compensation related loan tax consequences of foregone interest: salary
Corporate-Shareholder loan tax consequences of foregone interest: dividend (CG rate)

Term Loans
Amount loaned is equal to the present value of all payments due under the loan using AFR
Example: $100K 3 year semi-annual loan at 0%
o $74,620 (loan) +
o $25,398 (interest @ 10% semi-annually for three years)
This interest is taxable
Imputed Income
Imputed Income: the benefits derived from labor on ones own behalf or the benefits from ownership of property;
excluded from income under 61

But, we dont tax imputed income b/c of administrative difficulties and valuation problems
o Exception: barter transactions: We dont want people setting up barter coops to avoid taxation
This really has consequences for stay-at-home spousesno tax on that imputed income (but if you work & earn
wages which you use to pay someone to clean the house, youre taxed)
Imputed Income from Capital: We dont tax consumption value from car, home, etc.
Rev. Rul. 79-24: When people exchange services for services they both have gross income equal to the FMV of
the services (IRS doesnt usually enforce)

Morris (U.S. 1928)

Value of farm products consumed by owners of the farm is not income.
Do You Have to Work For Your Income?
Gifts

102(a): Gross income does not include the value of property acquired by gift, bequest, devise, or
inheritance
o Doesnt actually define what a gift is. Just says it is not included in gross income.
102(c): payment from Er to Ee can never be a gift (except, e.g., Er dad to Ee son for b-day)
274(b): No deduction allowed under 162 for gifts

Taxation of Gifts
1

Donor
Tax

Recipient
No tax

Notes
This is the law. We dont allow a deduction and we exclude it (102). Why?
- Dont want high bracket donors shifting income to low-bracket donees
- Administrative reason: Donor does nothing on income tax return when he
makes the gift; donee also does nothing. Under #2, donor has to deduct it
and donee has to include it. Concern is that donee wont include and
donor will deduct.
Used instead of #1 for certain forms of income

2
No tax
Tax
Duberstein (U.S. 1960)
If transferors intention proceeded from detached and disinterested generosity, then it is a gift. Must be
decided based on the facts of the case. Most critical consideration is transferors intent
Gifts of Property

1015: The basis of property for computing gain in the hands of a donee shall be the same as the basis in the hands
of the donor (carryover basis). The basis for computing loss is FMV.
o Ex: Gift-givers basis is $1K, but FMV is $600
Sold for $500: Gain= $0; Loss = $100

Sold for $600: Gain = $0, Loss = $0

Sold for $800: Gain = $0, Loss = $0
Sold for $1000: Gain = $0, Loss = $0
Sold for $1200: Gain = $200, Loss = $0
If the taxpayer cant establish the donors basis (after attempting to get it) the basis will be the FMV at the date
the property was acquired by the donor.
No gain or loss is recognized on transfer of property to a spouse. The transferees basis in the property is the
same as the transferors.

I have basis of $10K in a painting. FMV is $100K. If I sold it today, Id make $90K cap gain. But instead, I give it to
my son as a gift.
Tax to Me
Son (Basis)
Taxable Income to
Notes
Son if he sells
1 ( 1015)
No tax
Tax at $10K
$90K
Congress picks this one for gifts
the rule for appreciated property.
Carryover basis.
Bequests
1014: the basis of property acquired from a decedent is the FMV of the property at the date of the
decedents death
lt is a stepped up (or stepped down) basis for the transferee, and the accrued gain (or loss) on the property
will never be subject to income tax (or available to reduce tax)
For losses, this provision isnt such a boon:
o Hypo: I pay $250K and FMV is $100K, so I have untaxed depreciation rather than appreciation. Still not
a taxable event. Whats the result under 1014?
FMV ($100K). So 1014 isnt such a boon if youve incurred a loss on the property
Self-help remedy: Sell the property if youve incurred a loss
1022: Anyone who died in 2010 could choose how they wanted to be taxed [would get the lesser of decedents
adjusted basis and the FMV]

2 ( 1014)

Tax to Me

Son (Basis)

No tax

$100K

Taxable Income to
Son if he sells
None

Notes
For bequests only (b/c whenever I
have appreciated property, Id give it
to spouse or kid and avoid taxes)

Prizes and Awards

Generally included in income and taxable

Reg. 1.102-1(a) the gift exclusion under 102 does not apply to prizes and awards
74certain prizes are excludable if they are not retained by the recipient:
o Must be in recognition of religious, charitable, scientific, educational, artistic, literary or civic
achievement;
o Recipient must have taken no action to enter the contest;
o Recipient must not be required to render substantial future services; and
o The prize or award must be transferred to charity

Government Transfer Payments

Payments that are really in lieu of work/wages tend to be taxable
85: Unemployment benefits are generally taxable income

86: Social security is taxable over a certain threshold:

>$32,000 for joint filers 50% is taxable
>$44,000 for joint filers 85% is taxable
o Uses modified AGI to make the determination
911 We tax U.S. citizens on their worldwide income; doesnt matter where the $ is earnedits taxable.
Capital Appreciation and Recovery of Capital
Recovery of Capital Generally
Definitions
Gain = AR Basis [*You are only taxed on gain, not your initial investment (basis)]
AR = Sale price
Basis = way to keep track of the taxes that have already been paid on an item
Recovery of Capital
Expenses can be
o Immediately deductible (i.e., salary paid by Er)
o Capitalized (e.g., land)
o Depreciated (e.g., piece of machinery)
a. Determining Basis

Basis of Purchased Property = cost, except as otherwise provided.

o If purchased for cash, sale price = basis
o If exchanged for services, FMV of services = basis
o Even if the buyer under or overpaid, basis = cost paid, unless there is a special relationship between the
parties (ER/EE) in which case it will be recharacterized
Basis of Gift Property = basis of the donor
o Goal is to preserve the basis and tax it on a subsequent disposition
o But to determine loss, basis is lesser of donors basis and FMV.
Basis of Property Inherited
o FMV at the time of death of the decedent.
Basis of Property Exchanged
o You get the basis of the property you receive
Adjusted Basis (1016)
o Reflects capitalized expenditures, untaxed receipts, and certain losses, depreciation.

Basis AllocationPart Sale

A TP who sells only part of her property must allocate the basis
She must also calculate the gain and loss to each part at the time of the sale

Assuming no upward adjustments for improvements to the property or downward adjustments for depreciation
taken, this is the rule for allocation of basis w/r/t land:
Basis of Parcel Sold = Total Basis of all Parcels x

Value of Parcel Sold

Total Value of all Parcels

Must allocate based on FMV at the time of purchase!

Summary of Rules: (1) Allocate basis; (2) Allocate at FMV; (3) Allocate based on FMV at time of purchase
o Exceptions: involuntary transactions (Inaja Land)

Inaja Land (T.C. 1947) [Rare]

Taxpayer bought land and fishing rights, but later settled a lawsuit against the city for polluting the river. Under
the settlement, TP rcvd $50K and, in exchange, gave the city certain rights. IRS argued that taxpayer had to
allocate basishad to figure out how much $ was allocable to fishing rights when taxpayer first bought land.
Court treated it as tax-free recovery of capital. TP was allowed to allocate basis first to the rights
sold up to the sales proceeds.
Court focused on the fact that the transfer was involuntary.
Also, calculating basis would have been really difficult.
Gladen
Taxpayer buys property with unvested water rights. Later, the rights vest, taxpayer sells the water rights.
Taxpayer argues its just a return of capital.
Court requires TP to allocate basis to the water rights.
Voluntary transaction.
Basis AllocationPart Sale/Part Gift
Reg. 1.1015(4)(a): Where a transfer of property is in part a sale and in part a gift, the unadjusted basis of the
property in the hands of the transferee is the sum of:
o Whichever of the following is greater:
(1) Amount paid by transferee for the property, or
(2) Transferors adjusted basis for the property at the time of transfer
-ANDo The amount of increase, if any, in basis authorized by 1015 for gift tax paid
Allocate basis to the part sold up to the purchase price (unless to charity)
Hypo: I bought some property for $400. FMV is $1K. I sell it to my daughter for $500.
o Daughters Basis is $400
o FMV is $1000
Hypo: I bought property for $400. It has appreciated to $500. I sell it to daughter at cost for $500.
o Daughters basis is $500 (she just paid $500 and I had no unused basis to give to her)
o I have gain of $100
Hypo: I bought property for $600. FMV is $1000. I sell to daughter for $500.
o I get to allocate basis to part sold up to the purchase price. So daughters basis is still $500.
Hort (U.S. 1941)
TP is owed $160K in future payments for a lease. The lease is cancelled and TP is paid $140K. TP wants to
claim a $20K loss. TP wants to treat it as a return on capital.
Court held that $ paid as part of a cancellation of a lease, even if the cancellation of the lease overall leads
to a loss, is gross income, just as the rent payments would be. Loss is not FMV-AR. It is Basis AR.
Rule: Where property generates income, you dont allocate basis to those income rights. All basis
attaches to underlying property, not to rent. Loss = Basis AR. Money paid as part of cancellation of
a lease is income. This is a rent transaction, not a sale of property.
The lessees right to the property under the lease was a carved-out interest b/c the lessor continued to own
the lease property. For tax purposes, a carved-out interest is not a separate property right.

Example: I sell a rental property.

o If all I own is the right to the next 5 years of rental payments, and I sell those, I can use my basis. I
can also depreciate my basis b/c, to me, the property will be worth nothing in the end.
o But if I own both the right to the next 5 years and everything else (the remainder), I cant depreciate
my basis.

10

We need Hort to deal with problems caused by the Realization Doctrine. But we need 167 to deal with the
problems caused by Hort.

The rule is completely different w/r/t bonds: allocate basis between the value of the piece you are selling (i.e.,
the right to receive the final payment) and the piece youre keeping (i.e., the remainder).
Hypo: I buy a 10 year govt bond worth $100K. Interest rate is 10%. I should be able to sell the right to receive
the final payment at the end for $38K. Hort would say that you can get a big loss (all the basis goes to that end
piece). But that cant be the right result. So, with bonds, you have to allocate basis.
Realization

Realization doctrine: there is some triggering event such that we recognize the gain
o Recognition: whether were going to include it in this years income
Timing option: The realization reqt is inherently asymmetric
o Generally, taxpayer gets to choose when theres a realization eventnot the IRS
o Taxpayers will choose to defer gains and recognize losses
o A series of responses from the Code
Capital loss exception (cant take capital losses unless you have capital gain)
Wash Sales (substantially identical securities or stock) --1091
Straddle (when taxpayers own property w/offsetting positions) --1092
Mark to Market rules (abolishes realization reqt for certain taxpayers and certain types of
investments/contracts)
o View of realization reqt has shifted from Constitutional reqt (Eisner) to administrative doctrine (Cottage
Savings)

Treasure Trove is income in the year you find it. (Cesarini cash found in piano; would also apply to a ring you
find on the street)
*Note: theres a difference b/w treasure trove and a bargain purchase
Unsolicited Gifts: If you take a deduction, you have to include the gift in income first. If you dont take a
deduction, you dont have to include in income. (Haverly publisher sends books to principal as a gift; principal
gives them to the school library and takes a deduction).
No Realization, No Income?
Stock dividends are not taxed until realized. (Eisner)
o Hypo: 2 people (A&B) each put $1K into a corp. Corp earns $1K. What can the corp do? Possibilities:
Retain earnings. Each share becomes worth $1500 No realization eventjust appreciated
property
Pay a cash dividend. Income, taxed at CG rates.
Pay a stock dividend (i.e., give each of A & B an extra half share). No income.
o If you get stock dividends, the basis of the new stock should be determined by allocating b/w the new
and the adjusted basis of the old.
Rules for Landlords w/r/t Improvements by the Lessee
o 109: Landlord does not include in income any improvements made by the lessee until the property is
sold [NOT when the lease ends]. Landlord only receives income if the improvements are intended as a
substitute for rent.
o 1019: Landlords basis is NOT affected so the value of the improvements is recaptured upon
disposition b/c a lower basis yields increased gain
Cottage Savings (U.S. 1991)
S&Ls are engaging in swaps of essentially identical mortgages that are currently worth less than their face
value. They are doing this to create a realization event so they can take a loss and get a payout from the govt
but dont want to book the loss.

11

An exchange of property gives rise to a realization event under 1001(a) ONLY if the properties
exchanged are materially different. Properties are materially different so long as their respective
possessors enjoy legal entitlements that are different in kind of extent.
Reg. 1001-3: There is not even an exchange unless there is a significant modification
Test Today:
o (1) Was there a significant modification of the loan? [If so, there has been an exchange, and you
can move on to question 2]
o (2) Did the property exchanged differ materially in kind or extent? If so, then gain/loss is treated
as income/loss.
Annuities and Life Insurance

Annuities
Annuity: Transfer money to an institution (insurance company, for example). They pay you back the money
in installments.
Problem: How do we know what is basis and what is capital recovery?
For tax purposes, the annuitant has income to the extent he received more than he paid for the annuity (the
investment in the annuity is his basis).
Term over which you can be repaid can be (1) life (classic annuity) or (2) fixed term
72 Exclusion Ratio: Taxes a portion of each annuity payment and treats the remaining portion as a recovery of
payment. Sets an exclusion ratio where the numerator is the investment in the contract and the denominator is the
expected return (straight line depreciation):
Exclusion Ratio = Investment in K
Expected Return
Payment x (1 Exclusion Ratio) = Taxable Income

10% penalty for premature distributions

Only applies to natural persons (not corporations)

Potential to Abuse 72 [and Preventing it using 264]

Borrow $ to buy the annuity. Leads to a combination of income and deductionthe end result is you can use it
to write off other sources of income.
264: Prohibits debt financing of annuities altogether. If IRS is able to link the debt with the financing, you
dont get an interest deduction. [*Note: Easy to get around this. Take out a bigger mortgage on your home than
you need and use the funds to buy an annuity.]
Life Annuity: aggregate amount to be received is based on life expectancy of the person or persons whose lives
measure the period of the annuity
Reg. 1.72-9 provides life expectancy tables
Women are taxed more highly than men b/c women live longer
If you outlive your life expectancy, the entire payment in the year (or years) after you were expected to die is
taxed as income (so, penalty for living)
If you die prematurely, you get a deduction (so, reward for dying).
Deferred Annuity: TP pays for annuity where payments will begin at a later date. Amount grows in interest until the
beginning of payout.
Much larger tax benefit b/c you dont count income until pt. x. All that time youve been earning interest (if it
were in the bank, youd be paying $)

12

72(e): Can no longer borrow against the annuity and treat it as a loan; now its looked at as a distribution. So if
youre using the annuity as a savings account, you get taxed more harshly

Life Insurance
Term
Tax free when you get it
No deduction/loss if you live ( 101(a))
Receipt of the insurance + interest taxable if you die ( 101(a))
If proceeds arent paid out all at once, but instead over time, the interest is income (101(c))
Problem with term insurance is that its more likely you will die the older you get so the price goes up so
insurance industry created whole life insurance
Whole Life
Two parts of whole life:
o (1) Term Insurance (see above)
o (2) Savings account
Premium is initially set very high, invested back into a savings account and earns interest. Over time,
the insurance policy accumulates cash value.
Insurance company can take withdrawals from the account to pay the premium once theres enough
in the account
Even though the premium increases as taxpayer gets older, the savings cover the increase. By the
time you are 80, all thats left is essentially a savings account.
If you die early, policy proceeds payable to the beneficiary consist of pure insurance
If you die late, policy proceeds paid consist mostly of savings + accumulated interest
Taxation
Interest accrued in the account is tax free under 101(a)
Interest when you die is not taxed
You can borrow against the cash value in the life insurance without being taxed
If you cash out, you pay taxes on the excess of the costthis means that you can deduct all the term premiums
you paid (101(b))
o Ex: You pay $30K premium. Cash value is $45K. Close out and you get check for $45K. You have income
of $15K.
Free deduction of term insurance! Should be able to deduct the premium but not the costs! This is
just another way we subsidize whole life.
Terminally ill insured can get the insurance pay-out tax free at the end of their lives to help pay medical costs
(101(g)).
Treatment of Debt
General Treatment

Loans generally do NOT have tax consequences b/c no change in assets

Borrowerdoesnt have income b/c he gets $ but has an obligation
o If borrower cant pay back the loan and his debt is paid by a 3d pty, he either has income (Old Colony)
or a non-taxable gift
o If the debt is cancelled for less than its face value, he has income
Lenderdoesnt get deduction b/c the $ he gives out will be returned

Illegal Income (Embezzlement/Extortion)

13

We tax gains from criminal businessesno reason to treat them more leniently than legal businesses. But we
dont usually impose penalties (e.g., no deductions) on illegal businesses.
o Exception: 280E: No deductions for drug dealers
James v. U.S.: Money illegally acquired IS gross income when lack of consensual recognition of obligation to
repay
o If embezzler does repay, then he gets a deduction in the year in which he repays (165). 165(c) limits
how much he can deduct that year (BTL).

Gambling
Collins (2d Cir. 1993)
D works at the OTB. OTB has a specific rule that employees cant bet and that they dont extend credit for
bets. D sometimes borrows money to gamble, earns a profit and replaces the money he borrowed. This time
D borrows $80k in tickets (over the course of the day keeps losing) to bet. He loses $38k. IRS claims he
has $38K of gambling income [*Shuldiner: Its not really gambling income. They get the result right but
the reasoning is wrong.]
Court says that Collins illegal activities gave rise to gross income of $80K (gain from theft) and a
deduction for the restitution payment of $42K.
Loans are identified by the mutual understanding b/w borrower and lender of the obligation to
repay and a bona fide intent on the borrowers part to repay the acquired funds. Here, no such
consensual recognition.
164(d): Losses from wagering are only allowed to the extent of gains of such transactions. Gambling
losses can only be offset against gambling gainsnot other types of income.
Discharge of Indebtedness
61(a)(12): Discharge of indebtedness is included in income.
Anytime you pay back less principal than you borrowed, you have discharge of debt.
When you have DoI, always ask whether you can exclude it under an exception:
108 Exceptions
o 108(a)(2)(A): If debtor is insolvent, amount excluded is limited to the amount of insolvency [TPs
liabilities TPs assets]
Ex. I borrow $100K. My assets are only $40K. I go to the lender and renegotiate the deal, and
agree to pay $30K. Taxable income of $10K b/c the amt excluded cant exceed the amt by
which the debtor is insolvent.
But Congress wants something back after declaring that that $60K isnt income.
What do they take back?
o Net operating losses: If you have net biz losses in a year, govt doesnt pay
you. So here, you have to write down your losses by $60K. Not much of a
benefit then!
*Note: This would have been a deduction, so it is reduced dollar
for dollar by DoI.
o Credits: If you had various biz credits, youre going to lose them.
*What if I was carrying forward $100K in credits? Should you lose
$60K of those credits? No. Under 108(b)(3)(b), credits should
be reduced by 33.3 cents each dollar of DoI. So you only have to
reduce about $20K in credits.
o Capital loss carryovers: If you have losses and cant use them you get to
carry them forward.
o Basis reductions: 108(e)if you dont have NOLs or credits, were going to
reduce the basis in your property which will reduce gain when you
subsequently sell the property

14

o
o

o
o
o

108(a)(2)(B): discharge occurs during Title 11 Bankruptcy

108(e)(2): excluded from income if payment of debt would have given rise to a deduction (under 162,
167, etc.)
Ex: If janitorial services company cancels debt you owe them, the income is excluded b/c it
would have given rise to a biz expense under 162
108(e)(5) Purchase Price Reduction: Reduction in price owed to seller for purchase of property is NOT
treated as a discharge of indebtedness. Instead, just treated as an adjustment to basis. [*Refers only to
propertynot services]
108(e)(4) Treated as Gift: In a noncommercial setting, the discharge may be treated as a gift under 102.
Limitation: If a pty who is related to the debtor acquires the debt from an unrelated party, the
debt is treated as acquired by the debtor, which may result in income to the debtor.
108(f) Student Loan Forgiveness: Forgiveness of student loans are excluded (contingent on the
students working for certain period of time in certain professions and for a specific number of years).

Kirby (U.S. 1931)

Kirby issues bonds and then later buys them back at a discount b/c interest rates went up so bonds were kind of
worthless.
Kirby has income: issuing price/face value purchase price = gain/income.
Discharge of indebtedness is income
Ability to buy back bonds at a discount = income
Zarin (U.S. 1989)
TP has borrowed a lot of $ from a casino. He has a debt of $3.5M but they settle it for $500k. Is the
forgiveness of the $3M income? TP argues no b/c the debt was not illegally enforceable; it was a change in the
purchase price; did not get anything of value.
Forgiveness of debt is taxable income where the taxpayer received something of value in exchange
for the indebtednessgain is the amount that is freed up by not having to pay the lender.
[*Despite subsequent history, this is correct]. The only reason it was not taxed at time of receipt was b/c
of intent to repay. If duty to repay is forgiven, that is income under Rule 61 (despite the fact that its not
debt under 108(d)(1)).
Borrowing and Basis
Generally allowed to include amount of a loan in basis and then take deductions on that basis, under the assumption
that you will pay it back. But if a buyer buys the property and assumes the loan, you need to account for discharge of
the loan.
Recourse vs. Non-Recourse Debt
Recourse debt
o The borrower is personally liable for repayment of the debt
o Upon default, lender can look to all other assets of the borrower for repayment
Non-Recourse debt
o Borrower is not personally liable
o Lender can only look to borrowers assets that were used to secure the debt
o If a TP is relieved of a NR liability in connection w/the disposition of encumbered property, the
consequences are not determined under 61(a)(12) and 108.
Non-Recourse Debt
Crane (U.S. 1947)
TP inherits a building subject to a NR mortgage. She later sells the building. How do you determine her basis?
Recourse and nonrecourse debt are treated alike, and all loans are included in basis of the asset
they finance as well as the amount realized upon disposition of the property. Cranes basis was FMV

15

at the time of her husbands death, adjusted for depreciation in the interim.
Rule: Add debt to basis and to amount realized!
Cant take depreciation based on the FMV of the property + mortgage w/o actually including both of the
above in basis. The TP was able to take depreciation deductions on the property in excess of her cash
investment, so the debt relief has to be included in AR.

Tufts (U.S. 1983)

[Over-leveraged property]
Partnership borrows $1.8 NR loan to buy apartments. They took $450K in depreciation, which reduced their
basis to $1.4M. Partnership cant operate the building profitably so wants to sellhaving repaid none of the
principal on the loan, they sold the property to another investor. The investor paid them nothing, but took the
building subject to the mortgage. At the time, FMV was not greater than $1.4M adjusted basis. TPs argued that
no more than $1.4M should be included in their AR, so they had no recognizable gain (b/c, after taking
depreciation, basis in property was $1.4M.
Does the Crane rule apply when the value of the mortgage > FMV of property?
Crane applies even when the unpaid amt of the NR mortgage exceeds FMV of the property sold:
Still have to add debt to AR (and, of course, basis).
Cant use mortgage to assess basis and not include it in AR.
OConnor would have treated this like cancellation of indebtedness.
3 Scenarios:
Buyer assumes Debt over the FMV of the Property : You buy property for $100K, borrowing full amt. You
take depreciation of $20K. Your adjusted basis is $80K. FMV has dropped to $80K. Assume its non-recourse.
Assume its a sale and the buyer is assuming a debt. Tax consequences? [This is like Tuftsmajority]
o AR = face of the debt ($100K)
o Basis - $80K
So Gain = $20K (taxed as capital gain)
DoI = 0
o If we had adopted OConnor, we would have gain of $0; DoI of $20Ktreated as satisfying the debt
of $80K.
Could we use 108 to change this result? Could exclude the $20K from income under 108
(b/c it would otherwise have been a deduction) and reduce your basisbasis is now $60K.
AR is $80, Basis is $60, and you have gain of $20K (same result as majority, by a more
circuitous route).
Buyer assumes Debt up to FMV of the Property and Bank Discharges Some of the Loan: You buy property
for $100K, borrowing full amt. You take depreciation of $20K. Your adjusted basis is $80K. FMV has dropped
to $80K. Assume its non-recourse. Asks bank to write debt down to $80K. So bank explicitly agrees to cancel
$20K of the debt. Now you sell it for $80K, including assumption of debt by seller.
o DoI = $20K [Rev. Ruling 91-31: If you first explicitly cancel the debt it is treated as DoI. Different result
from Tufts]
o But, you still get to use 108 to exclude from income, reduce basis. You sell, and you have gain. Sell for
$80. Basis is reduced to $60K (still assuming $20K depreciation). Gain of $20K.
Purchase Price Reduction: What if you bought the property initially from some seller and rather than going to
bank for the debt, you just owe the seller $100K (non-recourse). You go back to the seller and say: Youre not
going to get $100K. Ill pay you $80K. Seller agrees.
o Under 108(e)(5) its a purchase price reduction So not DoI. Basis will drop. If you sell and someone
assumes the debt, you will have a basis of $60K (still assuming $20K depreciation).
Recourse Debt
Bifurcated Approach:
(1) Debt discharge included in AR, up to the FMV of the property; and
(2) Any addl debt discharge is treated as 61(a)(12) DoI

16

*Note: In the end, we treat NR and R debt differently (which contradicts Tufts) but in the end it doesnt really matter
very much b/c of 108.
Borrowing Money Against Property Already Owned
Merely borrowing, even on a NR basis, when secured only by untaxed appreciation in property a realization
event.
Hypo: I own prop w/FMV of $1 mil. My basis is $400K. No gain yetunrealized appreciation. I go to bank
and ask for $700K nonrecourse loan, secured by property. Should we view this as a partial sale? NO.
o *Note: If you give the property to your son, you would take income of $300K and son would take basis
in $700K. [If you give a gift subsequent to the debt, its part sale/part gift and the AR is the amount
of the NR debt]
Using Debt to Create Tax Shelters
Tax shelter designed to increase the amount of depreciation: Arrange to buy property at an inflated price, w/a real
down payment up front and a large payment scheduled (but never made) sometime in the distant future. The investor
gets basis = to the down payment + the unrealistic large future payment. The investor then takes inflated
depreciation deductions on the inflated basis for the property. Eventually, basis is reduced to 0 and investor defaults
on the loan. Balance of the loan is treated as having been received upon sale or foreclosure and the investor has to
recognize income and, in effect, give back the depreciation taken in earlier years. But the default and gain occurs
after many years of depreciation deductions have been taken, which makes the PV of the tax savings from the
annual depreciation deductions much greater than the PV of the tax cost on foreclosure.
Estate of Franklin (9th Cir. 1976)
[Sale/lease-back]
Pship purchases a motel for almost no $ up front, large balloon payment at the end, NR debt of $1.2M.
Immediately lease back the motel to the original owners, who were responsible for operating the property,
paying taxes, etc. Pship took interest deductions on debt and depreciation deductions calculated on the $1.2M
(under Crane). Deductions produced large losses used to offset gains made as docs. IRS wants to disallow
losses saying this is a sham acquisition or merely an option. Tax Ct says its an option. FMV is not really
$1.2M (more like $600K).
An investment in property exists only when the purchase price is approximately equivalent to its
FMV, thereby yielding an equity interest with the purchaser. Here, b/c the purchase price far exceeds
any reasonable estimate of the FMV of the property at the time of sale, the nonrecourse debt was not
genuine indebtedness, so the debt should not have been included in basis and did not produce interest or
depreciation deductions.
*Note: If FMV was $1M and debt was $1M, then theyd probably be able to include debt in basis.

Harsh result in Franklin: No one gets to take depreciation or the interest deduction (not even the original
owners).
Why shouldnt the docs at least get basis for the FMV of the property? Treat it as if its a real debt up to the
FMV of the property and allow depreciation on that amount. Other courts would allow this.

Pre-Paid Interest [461(g)]

You cant deduct pre-paid interest when you pay it. You can deduct it only when the interest actually accrues.
[*Only applies to cash-method TPs]
Damages and Sick Pay
Generally
Tax treatment of damages award depends on the nature of what was lost/what the damage award is a replacement
for.

17

Must distinguish between business and personal damages.

Business Damages
Hypo: You destroy my factory. I have lost profits, there are punitive dmgs, and loss of goodwill. What are the tax
consequences? Look at what the damages are a substitute for:

Lost profits Taxable as ordinary income b/c substituting for profits, which would have been taxable [AR
minus Basis]

Punitive dmgs Taxable as ordinary income. See Glenshaw Glass.

Loss of goodwill Not taxable (treated as a return of capital). This is a substitute for sale of goodwill. [AR
minus Basis]
o How do you get goodwill?
Advertising No basis
Having polite employees salaries of better employees (generally deductible)
The things you use to get good will are generally deductible
Generally no basis in goodwill, but not always true b/c you can purchase goodwill

Destroyed Building Treated as sale of the building [AR minus basis = gain]
o Is this a good result? Could be problems:
o You may want to rebuild the factory.
Ex: I have a $1 mil bldg that you destroy. I get $1 mil in dmgs. I want to rebuild but cant b/c 1/3 is
being taken for taxes.
o 1033: Exception for involuntary conversions
Dont realized any gain if you re-invest the money within 2 years and its similar property
Basis in new property is same as basis in the old propertymeans youll have to recognize gains
when you sell (allows deferral)

Settlement dmgs depends on whether its loss of profits, property, etc.

*Note: 186 allows taxpayers to reduce taxable dmgs to reflect earlier losses that they have not fully deducted.
o Intended to prevent injured pties who couldnt realize the benefit of loss deductions from being exposed
to full tax liability
o Deduction is the lesser of the compensation received OR the unrecovered losses sustained from the
injury.

Personal Damages
Hypo: I get hit by car. How are the following taxed?

Medical Expenses
o Uncompensated? Deductible under 213 (medical deduction) to the extent that such expenses exceed
7.5% of AGI (effective 2013 it goes to 10%, but if you and your spouse are over 65, wait until 2017) and
have to be itemized (we have to make sure it is not listed as an above-the-line deduction)
o Insurer paid?
Paid by employee:
Recovery on the insurance is excluded under 104(a)(3)
*Note: If you had the med expenses last year and deducted them last year, but get the
recovery this year, you CANNOT exclude the recovery this year (b/c youve already
deducted!). 104(a)

18

Paid by employer (either directly or through insurance):

Proceeds received are excluded to extent they are for medical care. 105(b)
What if employer just bought you the insurance. Is that income? No under 106.
Tortfeasor paid? Excluded under 104(a)(2) ONLY if for personal physical injuries or sickness.

Lost Wages
o Uncompensated? No income.
o Insurance?
Paid by employee:
Excluded under 104(a)(3) (and no deduction)
Paid by employer (directly or indirectly through insurance):
Not excluded
o Under 105(a) its income; no exception under 105(b) b/c deals only with
medical expenses [*Note: Exception in 105(c) if you have loss of a limb or
permanent disfigurement]
o Can take a deduction for paying for insurance.
o Inconsistency depending on who paid for the insurance.
Tortfeasor Excluded under 104(a)(2)
o *Note: Sick pay is taxable just like regular salary

Pain and Suffering

o Uncompensated? Taxable, no deduction.
o Paid by employer Taxable income under 105(a)
If Er is compensating you for lost limbs, then it wouldnt be taxable.
o Tortfeasor pays Not taxable under 104(a)(2)

Punitive Damages Taxable

Damage to Property (arising from physical injury?) (e.g., suit) Taxable as income b/c no exception
o Could maybe take a casualty loss (but, ltd to itemizers and has to be in excess of 10% of AGI so
would have to be a pretty nice suit!)
o

*Note: Under 104(a)(2), the ratio of economic to non-economic damages doesnt matter. Even if all your
harm was economic (lost wages), its still excluded b/c theres still a physical injury.

Non-Physical Harms
o The addition of physical to injury in the statute is recentthe IRS used to litigate non-physical injury
cases all the time.
o U.S. v. Burke (U.S. 1992) [first major win for the IRS]: Compensation on acct of sex discrimination was
not excludable. Court says that Title VII only permitted back-pay, not general tort like damages. Court
held that this wasnt covered by 104 b/c not a sufficiently tort-like claim. To be a tort-like claim, you
had to be permitted the whole range of damages.
*Note: After this case, Congress modified Title VII to expand the scope of damages, so you could
get full tort-like damages. Now damages are excludable.
o Schler (U.S. 1995): Age discrimination statute limited plaintiffs to lost wages. Court could have used
Burke analysis, but went further. Court found that, based on the plain language of 104, lost wages were
not on account of personal injuries.
What analysis is the court using? Not like the typical case (e.g., you get hit by a car which causes a
personal injury, which causes the lost wages). Courts analysis here is different (e.g., you get fired,
being fired causes the lost wages and the personal injury; so the personal injury did not cause the
lost wages). Weird reasoning.
Effect: removed broad classes of non-physical injury cases
Congress amends statute to eliminate non-physical injury

19

o
o

o
o

Discrimination claims Always taxable

Emotional Distress
If physical injury leads to emotional distress, dmgs are excluded under 104(a)(2) [cant exceed
amount paid for medical care]. But if b/c of emotional distress you have other losses, thats not
excluded.
If emotional distress leads to physical injury, not excluded.
Punitive Damages Taxable (not on account of the personal injury but the tort)
Damage to Property (e.g., suit) Taxable as income b/c no exception

Murphy: Emotional damages leading to physical injury. Murphy was fired from job and is blacklisted. She gets
a lot of physical symptoms as a result. Court said: As a constitutional issue, compensation for emotional harm is
not income.
o 2007: 61 can tax things that arent income. Court interprets the 1996 amendment as implicitly
amending 61 to include them. Power to do this b/c not a direct tax.
Tax Exempt Interest

103: Generally excludes interest on state and local bonds (muni bonds) from gross income
Exception: No exemption if the bond is not registered (i.e., is a bearer bond)
If Feds didnt allow the exclusion, states would have to pay more interest to bondholders to make up for
taxation
How these work [Assuming same tax rate40%--across the board]
Taxable bonds at 10% interest rate will pay out 6% after tax
Muni bonds will just pay out 6% (b/c not taxed)
o So in a world where everyone is taxed at equal rates, people are indifferent as to which bonds they buy
Problem: Everyone is NOT taxed at equal rates
Hypo: Rich taxpayer: 40% (wont buy unless 6%). Middle income: 20% (wont buy unless gets 8%). Poor: 0%
(wont buy unless 10%). If one muni bond is issued, who will buy it and at what rate?
o If muni is only issuing one bond, municipality will offer it at 6%. Problem: When they start to offer
more bonds, initially only the rich will buy.
o What if they issue more bonds after that (b/c no more rich people want to buy)? Theyll have to raise
the interest that theyre offering (to 8%). But theyll have to offer 8% to everyonecant price
discriminate. Now, the rich people are getting a real benefitinstead of taking home 6%, they are
taking home 8%. Govt should be getting 4% out of the rich person but is only getting 2% out of them
(the other 2% is staying in the pocket of the rich person). Now were not only subsidizing the
municipality but the rich people!
Proposed Solutions:
o Direct Subsidypay municipality directly.
If mkt rate is 10% on taxable bonds, municipality will pay 10% and we give them a subsidy
of 3.5%. Net pay is 6.5%
o Tax Credit to Purchaser of the Bonds
If you go out and by a muni bond, well give you a tax credit of $3.5%. So now, the
municipality gives TP 6.5% (taxable), fed govt gives them 3.5% (taxable) and they get 10%.
o Municipalities dont like these proposed reforms. Why?
Politics. Congress can set limits.
These are spending programsRepublicans like tax decreases rather than credits
Tax expenditures are hidden compared to spending which is exposed.
Arbitrage Problems & Solutions
3 Different Kinds of Arbitrage [103]

20

Issuer Arbitrage: When issuer uses bond (borrows) to purchase other debt at a higher yield
Buyer buys $1K muni bond at 6.5%. Municipality uses the $1K from the buyer to buy a treasury bond at 10%.
So the municipality pays out $65/year to muni buyer but gets back $100/year from the feds. Makes $35!
103: Exempts arbitrage bonds from tax free status
Holder Arbitrage: When an investor borrows at a commercial rate and invests at a tax-exempt rate
I borrow $1K at 10%. I pay $100/year but deduct those payments, so after-tax cost at 3.5% is $65. I use the $1K
to buy munis paying 8%. I get $80/year.
265(a)(2): No deduction for interest on indebtedness incurred or continued to purchase or carry obligations the
interest on which is wholly exempt from the taxes imposed by this subtitle
o Rarely enforced, should probably be repealed
o Can we argue that this provision actually helps rich people?
Would incentivize rich people to buy too many of these bondswill push down the interest
rate.
Now all the rich people own the muni bonds at 6%, which is what we wanted.
Private Activity Bond
Municipality borrows at the low rate and then lends out the money to residents of the city at the lower rate for
mortgagesmunicipality is passing the exemption along.
103(b)(1): Restricts this activity. Interest from these bonds is include in income (except for certain facilities:
docks/wharves, airports, sewage facilities, etc.)

Summary
INCLUDABLE VS. EXCLUDABLE INCOME ITEMS
The following shows whether certain items are includable or excludable as income to the recipient:
INCLUDABLE

EXCLUDABLE

Compensation for services

Meals and lodging for employers convenience

Gratuities and tips

Gifts and inheritance

Most interest payments

Punitive damages

Interest on state and local bonds

Damages for personal physical injury

Spousal support

Child support

Cancellation of indebtedness

Repayment of indebtedness

Prizes

Contribution to capital

Gambling winnings

Life and medical insurance recovery

Earnings for illegal activities

Recovery of cost of annuity contract

21

DEDUCTIONS AND CREDITS

Overview
(Gross Income) (ATL Deductions) = (Adjusted Gross Income)
(AGI) (BTL Deductions) = (Taxable Income)
Principal Substantive Sections
162Ordinary and necessary biz expenses (requires you to have a trade or biz).
o NOT personal activities
o NOT investment and sporadic profit-making activities that dont rise to the level of trade or biz
o Ex: rent, salaries, insurance, advertising, etc.
163-interest

22

164-taxes
165-losses
167/68/79/97 Depreciation/Amortization
212- for-profit activities that dont rise to the level of a trade or biz
o More likely to be below the line
o 212 (below the line) expenses are miscellaneous itemized deductions and are subject to the 2% limitation
Investment expenses (below the line)not listed in 62
Renting out property (if does not rise to level of a trade or biz) ( 62(a)(4))

Order of Analysis
(1)
(2)
(3)
(4)

Is there a provision creating a deduction? (see list above)

If so, does 62 explicitly list the deduction as ATL?
If not, it is BTL and we have to itemize under 63.
Is it a miscellaneous itemized deduction under 67? If not on the list in 67 it is a miscellaneous itemized
deduction and is subject to the 2% floor: can only take miscellaneous itemized deductions to the extent that
the amount of your aggregate deductions exceeds AGI.
List in 67 includes: interest (163), taxes (164), casualty/theft losses (165(a)), losses (165(d)),
charitable contributions (170), medical expenses (213), deduction for impairment-related work
expenses, etc.
(5) [If income is over the threshold in 68, you get a 3% haircut on almost every itemized deduction but this
provision isnt coming back until 2013.]
Business Expenses
Introduction
162: There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during
the taxable year in carrying on any trade or business. [Includes (1) reasonable allowance for salaries or other
compensation for personal services actually rendered; (2) traveling expenses (including amounts expended for meals
and lodging other than amounts which are lavish or extravagant under the circumstances) while away form home in
the pursuit of a trade or business; (3) rentals or other payments required to be made as a condition to the continued
use or possession, for purposes of the trade or business, of property to which the TP has not taken or is not taking
title, or in which he has no equity.]

Current expenses can be deducted immediately; cap expenses over time

Employer pays 132 working condn fringe
Employer biz expenses are ATL (includes expenses of Independent Contractors)
o Subtracted from gross income to get AGI
Employee biz expenses that are reimbursed are ATL.
o If amt reimbursed by Er = amt paid by Ee, Ee can disregard w/r/t reporting
o Requires substantiation
Employee biz expenses that are not reimbursed are BTL
o They are miscellaneous itemized deductions and are subject to the 2% floor. So most Ees are not
able to deduct unreimbursed biz expenses.
o Even if Ees unreimbursed biz expenses exceed the 2% floor, TP is allowed a deduction only if the TP
itemizes (i.e., doesnt take the standard deduction).
o Exceptions for performing artists, and military transportation

Elements of 162
What is a Trade or Business?

23

Not entirely clear.

Under Groetzinger, court says that to be in a T or B, you have to be engaged in the activity with
continuity/regularity. Primary purpose for engaging in the activity must be for income or profit.

What is Paid or Incurred?

Paid in case of cash-basis TP (individuals)
Accrued in case of accrual-basis TP
What is Carrying On?

T or B must have already started

Cant deduct start-up expenses (except certain start up expenses under 195)

What is Ordinary & Necessary?

Welch (U.S. 1933)
Taxpayer involved in grain biz. Biz goes bankrupt. Taxpayer goes out on his own to start up new biz. He
decides the way to do it is to pay off the debts of the old biz. Now he wants to deduct those payments. Held:
Not deductible. Cap expense.
Necessary: appropriate and helpful (citing McCulloch v. Maryland) [easy test]

Ordinary: fact-based determination with 3 themes:

o (1) Capital v. Current If its a capital expense (including reputation and learning), its not ordinary
o (2) Personal v. Business If its personal, then its not ordinary
o (3) Uncommon/Bizarre Nature of the Expense

Gilliam (T.C. 1986)

Gilliam is an artist w/history of psychiatric problems. He gets on a plane to go on a biz trip, has an episode
freaks out, hurts a couple of people. Is indicted but let off. He is trying to deduct his legal fees for his defense.
Held: Not deductible. Cap Expense.
Test for legal fees: What is the origin of the claim? If origin is personal, not deductible. If its business,
then deductible.
This just isnt common enoughwould have to be more frequent.
Compare Dancer: TP was driving a car for biz and hit a child. Court allowed deduction of legal expenses
b/c more direct relationship b/w the driving and his employment.
Public Policy Limitations
Tellier (U.S. 1966)
Tellier was a broker who violated fraud section of Securities Act. Claimed deduction for legal expenses.
Court allows deductionorigin of the claim was Telliers biz activities
An exception should be made to disallow an otherwise permissible 162 deduction only in the most
serious of cases (frustrating national policies, for example)
No public policy offended by employing a lawyer

162(f) cant deduct fines paid to government for violation of law

o civil as well as crim penalties are included in this (Reg. 1.162-21(b)(1)
o compensatory damages are NOT fines or penalties (Reg. 1.162-21)(b)(2)
o could argue fine only to disgorge the profits is NOT a fine or penalty.
o liquidated damages are not fines or penalties (Mason & Dixon Lines v. US)
162(c) cant deduct bribes to public officials
162(g) cant deduct 2/3 of any treble damages paid when convicted of antitrust violations

24

280(e) cant deduct any expenses related to drug activity

165 limit on deductibility of losses that would frustrate sharply defined national or state policies proscribing
particular types of conduct, payments that would not pass muster under 162 should not be deductible under
165

Business Lobbying
162(e): Generally NOT deductible [includes any amount paid in connection with (A) influencing legislation; (B)
participation in, or intervention in, any political campaign on behalf of (or in opposition to) any candidate for public
office; (C) Any attempt to influence the general public, or segments thereof, w/r/t elections, legislative matters, or
referendums, or (D) any direct communication w/a covered executive branch official in an attempt to influence the
official actions or positions of such official]
Exceptions for (1) de minimis expenses ($2K); (2) can lobby officials but not state and federal
501(h): Restricts lobbying for charitable organizations
Reasonable Compensation
162(a)(1): deductions allowed for all ordinary and necessary expenses in carrying on any trade or biz including:
reasonable allowance for salaries and other compensation for personal services actually rendered.
162(m): limits deduction for certain compensation to $1 mil in public corps; limited to top 5 employees; doesnt
apply to commissions or incentive based pay
280G: limits golden parachute payments to 3x base payotherwise, tax consequences
Two Main Tests to Determine Reasonableness:
(1) Seven Factor Test [court sits as super-personnel department]: type of services rendered, scarcity of
qualified Ees, qualifications and prior earning capacity of Ee, contributions of Ee to biz venture, net earnings of
Er, prevailing compensation paid to Ees with comparable jobs, peculiar characteristics
(2) Independent Investor Test (see Exacto)
Exacto Spring (7th Cir. 1999)
Exacto, a closely-held corp., paid its cofounder and CEO $1.3 and $1.0 million in salary in 1993 and 1994,
respectively. Tax court found the maximum reasonable compensation under 162(a)(1) for both years was
$900K and $700K applied a 7-factor test.
Uses Independent Investor Test: As long as investor is getting a reasonable rate of return, theres
reason to believe that the salary is ok. The higher a rate of return a corp is getting on its
investment (the salary), the higher the salary can be.
Rejects the 7 factor test, but Reed thinks it would have worked just fine
Domestic Product Deduction
199: subsidizes manufacturing activities w/in U.S.
Get a deduction for 9% of net domestic manufacturing income (cant exceed 50% of wages)
Probably a misguided attempt to encourage domestic manufacturing
Raises technical issues:
o Ex. When Starbucks roasts the coffee beans, is that domestic manufacturer? Yes. When they brew the
coffee, is that? No, thats probably services. [silly distinctions]
Employee Business Expenses and the 2% Floor
[See Intro Section under Business Expenses]
67: Miscellaneous itemized deductions

25

Hypo: AGI is $100K. Misc itemized expenses total $2500. 2% of AGI is $2000. B/c misc itemized expenses
exceed that by $500, you can deduct $500.
o Most people will get 0. Most people are routinely under the 2% floor.
Effects of various phase-out rules and floors is to increase the marginal rate on income while leaving the rate on
deductions the same. So if Im already over the cap, then my deductions are deductible at 25% but my income is
taxed at a higher rate based on the 2% floor. If Im under the cap, then I have no deduction for misc itemized
deduction, and rate on income is 25%.
o Hypo 1 [under the floor]: I pay a 25% tax rate. Im considering another $100 in expenses. Im well
under the floor. Will I be able to deduct those expenses? No. So my tax rate on my expenses is 0 (b/c
non-deductible).
What if I get another $100 of income? Tax rate on that income is 25%. AGI goes up $100,
taxable income goes up $100. I pay $25 (25%).
o Hypo 2 [over the floor]: Now consider a taxpayer who is over the floor. I already have $2500 in
expenses. Now Im considering another $100 of expenses. Tax rate on the extra $100 expenses is 25%.
What if I get another $100 of income? Taxable income will go up $100 b/c income went up $100.
My 2% floor goes up to $2,002 (from $2000), so I lose $2. So taxable income goes up by
$102. My tax on that would be $25.50. SO, my tax rate is now 25.5%
o Hypo 3: I earn $100K. 2% of AGI is $2K. I have $2500 in misc deductions. I go to AC: win $100K and,
on next roll, lose $100K. What does this do to my tax liability?
On some level, nothing has happened
What will happen to AGI? Increase $100K b/c gambling gains go into AGI. So AGI = $200K.
Can deduct $100K loss (up to amt of gainso fully deductible) BTL (b/c not listed in
62).
So are you home free? No b/c 2% cap just doubled (went from $2K to $4K) and I could
lose up to another $2K of miscellaneous itemized deductions (in our example, I had $2500
so I lost all $500).
Bizarre result (Income is ATL, but offsetting expense is BTLas a result AGI goes up &
2% floor goes up.)
Distinguishing Personal and Business Expenses

Generally
262: except as otherwise provided, no deductions shall be allowed for personal, living, or family expenses
Income = Consumption + Savings. If we allowed a deduction on personal consumption, the income tax would be a
savings tax.
Clothing
Deductible if:
(1) Clothing is a condition of employment;
(2) Is not adaptable to general usage; and
(3) Is not so worn
Pevnser (5th Cir. 1980)
Woman expected by her employer to wear designer clothing for boutique, Yves St. Laurent Rive Gauche in
Dallas. Took roughly $1,500 deduction for the taxable year, arguing that she didnt wear it outside of work b/c
didnt fit with her lifestyle.
Test should be objective: whether the clothing is adaptable to ordinary wear.
*Reed: Theres a difference b/w how successful youll be if youre not reimbursed vs. whether it is a
working condn fringe, even though theyre really the same thing.
*Reed: You might think that, if the boutique had supplied Pevsner with clothes, that it was a working

26

condn fringe, but in reality, we run into the same problem under 162not deductible! [Unless Er
supplied the clothes/Ee bought the clothes and thye could ONLY be worn on the biz premises then,
deductible.]
Child Care

21: TP is allowed a credit for certain dependent care that enables TP to work.
o Limited to $3K if there is only one qualifying individual or $6K if there are two or more.
o For less than $15K, credit starting at 35% and then phased down to 20%. Decrease of 1 percentage point
for every $2K that the TPs AGI is over $15K. Decrease of 1 percentage point for each fraction of $2K as
well.
o Hypo: Kim and Mike are married w/one kid. They each earn $10K for a total of $20K. The cost for child
care to enable Mike to work is $2K. What amount of tax credit will they be allowed?
$20K - $15- $5K So, 3 points reduction (32%)
.32 x $2K = $650
o If you earn $15K and pay $100 for child care expenses, you get a $35 credit.
o If you are at the 20% level, and you had that $100 expense, youd only get $20
129: exclusion for employer provided care
o Technically its an exclusion but Shuldiner wants to think of it as a deduction
o If shift cost over to Ers, it doesnt go to Ees gross income. This is technically an exclusion but its more
like a deduction than a credit. Its like it went into income and Ee got a deduction.
o *Note: Whatever $ Er gives you through 129 exclusion is deducted from the 21 credit you would
otherwise getcant benefit from both
o 125 Cafeteria Plans: choice between tax-free childcare or cash produces an ATL deduction for
childcare costs up to $5K

Hobby Losses and 183

183: In the case of an activity engaged in by an individual or an S corp, if such activity is not engaged in for
profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this
section.
183(b)(1) allows deductions which would be allowable under this chapter for the taxable year, regardless of
whether or not such activity is engaged in for profit (e.g., home mortgage interest, state/local property taxes)
183(b)(2) Should at least be able to take up to your gross income. Clearly an allowance provision
o Ex: Gross income: $10K. Interest plus taxes: $6K. Expenses: $8K. How much can you deduct?
$6K ( 183(b)(1))
$4K of the $8K can be deducted (183(b)(2)up to your gross income)
183(d) rebuttable presumption that enterprise is a profit-making venture if is profitable 3 years out of 5; or
2 out of 7 if you are breeding or showing horses
o If TP fails to satisfy the presumption, can still show that the activity was engaged in for profit.
Plunkett (T.C. 1984)
TP wants to deduct losses from mud racing and truck pulling and offset them against his regular income from
being an engineer.
Subjective Standard: Did TP engage in the activity with the actual and honest objective of making a
profit?
Court considers a number of factors and finds that he could deduct losses from truck-pulling but not mudracing.
Very fact specific: manner in which TP carries on the activity, expertise of TP, time and effort expended by
TP in carrying on the activity, expectation that assets used may appreciate, success of TP in carrying on
similar/dissimilar activities, TPs history of income/loss in the activity, amt of occasional profits earned,
financial status of TP, whether elements of personal pleasure or recreation are involved

27

Travel Away From Home

Overnight Rule: away from home does not include any trip not requiring sleep or rest
What is a Home?
Hantzis (1st Cir. 1981)
Harvard law student spent summer in NYC, claims Boston is home and that stay in NYC was business related,
temporary, and away from home. She deducts her expenses for the summer. Held: Not deductible b/c no biz
reason for the Boston home.
If youre residing in 2 homes, you have to have a biz reason for both homes in order to deduct the
extra one.
Temporary employment doctrine [ 162(a)]: TPs can deduct transportation, meals, and lodging expenses when
assigned to work in a place away from home for less than one year. TP must still have biz reason for maintaining
old home (e.g., plan to return to work there).
Meals may not be duplicative. And what if youre subletting your main home so youre not paying double rent?
Courts may take all of this into consideration.
If no regular abode, no deduction; has to be somewhere where youre incurring duplicative living expenses
Exception for legislators: members of Congress have to maintain residences in home districts. 162(a) provides
that home district is treated as tax home, but no more than $3K in living expenses can be deducted each year
Foreign Conventions: No deduction allowed for expenses for a convention/meeting outside of U.S. unless its
as reasonable for the meeting to be held outside of the U.S. as within it.
Transportation and Commuting
Generally: Commuting to and from work isnt deductible
Exception: Can be deductible when done through the Er under 132 (parking passes, transit passes, etc.)
Why? Personal decision to live where you do.
o McCabe v. Commissioner (2d Cir. 1982): PO employed by NYC was required to carry his service
revolver at all times while in city. Couldnt take the most direct route from his home outside of the city to
NYC b/c that route went through NJ where he wasnt licensed to have a gun. So he had to take an
indirect route. He tries to deduct travel expenses (under Fausner). Court says no. Personal decn to live
far away.

Rules
o Lawyer drives from home to worknot deductible
o Lawyer drives from work to client A deductible
o Lawyer drives from client A to home deductible
*Note: Has to be part of the same trade or business (?)
o If your home is also your office, then travel to a secondary office is deductible
o If you have no regular place of biz, then if you go outside of the metro area to a temporary place of biz,
its deductible. Otherwise its not.
o If you have more than one regular work location, you may deduct daily transportation expenses incurred
in going b/w TPs residence and a temporary work location in the same trade or biz

Tools of the Trade Exception: Exception for additional expenses that may at times be incurred for transporting
job-required tools and material to and from work
o Revenue Ruling 75-380: deductions permitted for only the portion of the cost of transporting the work
implements by the mode of transportation used which is in excess of the cost of commuting by the same
mode of transportation without the work implements

Working and Driving Exception

28

o
o

If PO is on duty the moment he leaves his home, he can deduct his driving expenses
BUT: B is driving into the city and working the entire time on phone Not deductible. Why? The
driving is merely incidental. Lawyer is doing biz but nothing about the biz is connected to the drive
(unlike PO)

Food and Lodging

Cant be lavish/extravagant, but first class airfare is ok
2 different categories of meals:
o Deductible b/c youre traveling
o Deductible w/o regard to traveling b/c specific biz nexus surrounding that meal
Could argue that meals are duplicativeyou could allocate
Meals and Entertainment
If expense is different from or in excess of personal expense, then deductible. Easy standard (Moss)
If you have dinner with a client, you get the deduction for both meals. If sufficient biz context, deductible.
Moss (T.C. 1983)
Law firm partner goes to lunch w/entire law firm (small) every day of the week. Wants to deduct expense of his
lunches.
In close cases, 262 will trump 162. Daily work lunch at restaurant is not deductible.
Different from taking a client out to lunch: social lubrication is necessary for clients, but not for
colleagues. Also different b/c client usually picks the restaurant.
Problem is that these lunches happened every day
274(d): in case of traveling expenses that includes entertainment, amusement and recreation (includes meals),
those expenses must be substantiated (statutorily overruled the Cohan case)
Ways around it per diem allowance
274(n): Only 50% of mean and entertainment expenses are deductible. We just know there ie some personal
component.
274(e)
Exceptions to the rule.
o Includes food and beverages furnished to the employee on the premises
o Expenses intended as compensation (should be fully deductible to ER and taxable to EE)
o Reimbursed expenses
Ex: EE pays for a legit business meal. He gets reimbursed. EE has no income and no
deduction. ER gets a deduction, but its still only 50%.
o 50% Limitation does not apply to expenses for food and beverages that would be excluded by the
recipient as a de minimis fringe under 132(e) (e.g., cafeteria that qualifies under 119)
Home Office Expenses
280A(a): Deduction for qualified home office expenses. Space must be used exclusively for business on a regular
basis.
Exceptions under 280A(b): If it would have been deductible anyway (mortgage interest, real estate taxes, etc.),
there wont be a disallowance b/c of the partial business use.
280A(c): Space must be used
(1) exclusively for business;
(2) on a regular basis

29

(3) as the principal place of business for the taxpayer; or

(4) as a place of biz used by patients, clients, or customers; or
(5) If it is a separate structure not attached to the dwelling, it must be used in connection with taxpayers trade
or biz
Flush Language: If youre an Ee, you have to meet the test of used for convenience of the employer

280A(c)(1)(C): PPB includes place of biz if:

(1) taxpayer uses it for admin or mgmt activities of any T or B and
(2) if there is no other fixed location of such T or B where the taxpayer conducts substantial admin or mgmt
activities of such T or B. [*VERY pro-taxpayer statute]
o Fixed Trucker doesnt qualify
o Taxpayer even if he hires personnel to conduct the biz, he still wins
o Even if taxpayer conducts occasional activities in the office, he wins if his activities are substantial in
the fixed location.
280A(c)(5): Limitation on Deductions: deductions allowed under this chapter for the taxable year by reason of being
attributed to such use shall not exceed the excess of
(A) Gross income derived from use

(B(i)) Deductions allocable to such use allowable whether such interest was used
+
(B(ii)) Deductions allocable to the trade or business in which such use occurs
o

*REMEMBER TO ALLOCATE

Hypo: Assume I have a consulting biz run out of home. Income is $2K. I pay interest & taxes on home of $5K.
Depreciation and utilities for home are $10K. I have an occasional assistant who I pay a salary of $1,200. What
is my permitted deduction?
o [280A is only concerned w/deductions related to the residence, so the employees salary isnt impacted
its not w/r/t the use of the dwelling]
o (A) Gross income derived from use is $2K
Must allocate income (b/w income from home-related activities and non-home). How do you
do this?? Very unclear.
o (B)(i) refers to interest and taxes ($5K)
You dont take the full $5Kyou have to allocate the part thats used for business. Divide it up
by space. 10% of the house, lets say. $500
o (B)(ii) refers to the salary
$1200 doesnt come under 280A b/c not in respect to use of dwelling
o Calculation
$2K [500 + 1200] = $300
o Depreciation and utilities ($10K)
$10K is for entire house, so allocate the part thats used for business. If that is 10%, then its
$1,000.
The percentage of the $1000 can be deducted is determined by the above calculation. So of the
$1K I would like to deduct I am only allowed a deduction of $300 (not the $700).
What about the $700 I cant deduct? You get to carry forward the amount to the following year
(even if you move out of the house). Then you apply the same set of rules.
This is an indefinite carry-forward. It becomes a potentially limited deduction in year 2. If it is
in fact limited in year 2, it can be carried forward to year 3. And so on, until its a qualified
expense.

280A(c)(6): Disallows deductions from the following creative end-run around the law:

30

Im an accountant. I want a home office but its not for the convenience of employer. So I ask Er to reduce my
salary by $5K and rent out a room in my house for $5K which I will use sometimes to work from home. Its no
longer my business of being an Ee, its my business of running a rental business. So now, Im running a rental
biz out of my house. So I can deduct (if not for 280A(c)(6)).
Current vs. Capital Expenditures

General

263 disallows deduction of capital expenditures

When an amount must be capitalized, it is added to the TPs basis in the asset w/r/t which the expenditure is
incurred
This amount will be recovered when the asset is sold or over some period of time during which the asset is held,
through a series of deductions called depreciation or amortization
If all expenditures made for business or investment were immediately deductible, tax would be imposed on
consumption, rather than income.
The effect of an immediate deduction is equivalent to not taxing return from capital (i.e., living in a notax world). Would allow taxpayers to postpone tax liability on the income offset by the deduction. (See
examples below)

IRAs

Tradl IRA:
o Only taxed when you withdraw $ ( 219)
o During the life, no tax ( 408(e)(1))
o When you take it out you pay tax at ordinary rate
o Net tax on investment in IRA: zero, as long as the tax rate stays the same.
Effective Tax = 0%
Simply an example of deducting your savings.
o Ex. Imagine you have non-dividend paying stock. You invest in IRA: taxed on all gain at ordinary
income rates (35%). Invest outside IRA: preferential cap gains rates (15%). Youd rather invest inside
the IRA b/c 0% is better than any preferential rate (as long as the tax is the same when you go in as
when you go out).
Roth IRA:
o When you invest you get nothing. No deduction.
o No tax over the life
o When you take it out, youre not taxed
o Effective tax rate = 0%
Because the effective tax rate is the same for both, theoretically it doesnt matter whether you invest in a tradl
or Roth IRA. But practically it does.

Why might you prefer one over the other?

TRADITIONAL
Life Cycle
If you think your tax bracket will go
down.
Amount You Can Put In
Income

Govt owns a shareyou share the

$5K limit with the govt
If you or your spouse has a
retirement acct with an employer,

ROTH
If you think tax rates will go up
generally or if your particular tax
bracket will go up.
Can put more in--$5K not shared
w/govt (i.e., pre-tax dollars)
Doesnt matter whether youre in a
qualified plan or not. Can use this up

31

Retirement Acct vs. Savings

Premature Distributions

you cant have a tradl IRA unless

youre low income ($89K married
filing jointly)
When you reach 70 , you have to
start withdrawing funds and you
cant make any more investments
All taxable upon withdrawal and
10% penalty if you withdraw too
soon.

to $167 married filing jointly.

No restrictions. Can use it as a taxfree savings vehicle.
If you make premature distribution
under age 59 , and you take
everything out, there is a 10%
penalty but only on income
(excludes basis). This rule doesnt
apply if you take a distribution for
certain medical/educational
expenses, first time home purchase,
annuitizing, call to active duty, etc.
But if its not a qualified
distribution, then you dont get the
no-tax rule (in which case your basis
is also taxable as income).

Acquisition and Disposition of Assets

[*Note: Just b/c something has to be capitalized doesnt mean its a capital asset.]
263 generally requires capitalization of amounts paid to acquire, produce or improve: (i) real or personal
property (including land, buildings, machinery or equipment) or (ii) intangibles. TPs must also capitalize
transaction costs incurred to facilitate an acquisition or certain other transactions.
*Note: 263 trumps 162. If something appears to be an ordinary and necessary expense, and thus deductible
under 162, but is included in the list in 263 (cap expenditures), then the expense must be capitalized.
What Costs Have to be Capitalized?
Depends on:
o What type of asset? (tangible or intangible?)
More likely youll have to capitalize w/r/t tangible assets (e.g., machinery) than intangible
(e.g., building up customer base)
o Connection b/w cost and asset? (direct or indirect?)
The more direct the connection, the more likely you are to have to capitalize
I build carsthe material going into the cars has to be capitalized
Materials that are consumed during production of the car but that dont go into the
car (services of people in the back office during construction)less direct
o Internal vs. External costs
More likely that youll have to capitalize the external costs than the internal costs
I pay a law firm to facilitate the acquisition of another biz (external)
I pay my internal lawyers to do the same (internal)

Examples of things that must be capitalized: cost of stock; brokers fee on purchase/sale of stock; debt
incurred to buy stock (even though interest is generally deductible); lawyers fees for acquiring another business;
a computer for your business; etc.

Woodward (U.S. 1970)

Whether the fees used to pay lawyers/accountants during appraisal proceedings are deductible or whether they
must be capitalized. Held: Must be capitalized.
Origin of the claim was the purchase of the stockdetermining the price of an asset is an integral

32

part of the purchase of an asset. [*Note: no indication that internal costs must be capitalized]
The Code
263(a)(1)(a): disallows deduction (i.e., requires capitalization) for any amount paid out of new buildings or
for permanent improvements or betterments made to increase value of property/estate
o Construction costs: costs of constructing capital asset (e.g., wages, supplies, etc.) must be capitalized.
May have to allocate:
Idaho Power: Big crane spends time working on building and other in garage. Capitalize
normal depreciation into projects basis and recognize depreciation as usual for other
corresponding to time spent idle. Have to allocate between parts used for constructing
building and everything else. Parts used for constructing building must be capitalized.
280B: disallows deduction of expenses for demolition of structures and requires that the costs be added to the
basis of the land
o Ex: Pay $400K for land and building. Tear down the building (which costs $5K) and build a new house.
How do you account for that?
Allocate between the building and the land ($50K to building, $350K to land).
You tore down the building, so you cant take a loss. Must add the buildings basis to the land
so now the basis of the land is $400K. PLUS cost of demolition. So, total basis is $405K.
263A Uniform Capitalization Rules: capitalization and inclusion in inventory costs of certain expenses; must
capitalize all direct and indirect costs incurred in acquisition of cap assets
o Applies to:
(1) Property produced by the TP; and
(2) Property acquired for resale
Hypo: Im GMI make and sell cars. Im WalMartI buy and sell merchandise.
Both are covered by 263A.
o Does not apply to mom-and-pop stores, freelance authors, photographers, or artists.
o Produce means: construct, build, install, manufacture, develop or improve
o What costs are being capitalized here?
Tangible assets: both direct and indirect, internal and external (film, sound/video recordings,
books, etc.)
Intangible assets:
If I produce intangible assets (e.g., copyright), NOT capitalized.
But resale items may include intangibles b/c it includes personal property. So, can
include things like copyrights.
o If I have a biz of buying and selling copyrights, this section applies. But if
Im creating a copyright, this doesnt apply.

263A(f): Special rules for Allocation of Interest to Property Produced by TP

o Must capitalize interest incurred during the production period. Indirectly taxes imputed income.
o Provision is limited in scope, more limited than rest of 263A
Debt has to be paid or incurred during production period
And allocable that to property that is built by taxpayer
And that property must have
long useful life;
an estimated production period of over 2 years; or
an estimated production period of over 1 year with cost of over $1M.

Acquisition of Intangible Assets or Benefits

Key Questions are the same as above:
(1) Internal/external?
(2) Direct/Indirect?
(3) Ordinary (recurring)/non-recurring?

33

Pre-INDOPCO, the court discussed several different guideposts for capitalization:

(1) One year guidepost: Capital expenditure is one that secures an advantage to the TP which is more than one
year, and TP must acquire something of use and value in his business (TP should reasonably anticipate a gain
that is more or less permanentmore than 1 year). (Fall River Gas)
(2) Non-recurring Expenditure Standard: Ordinariness of costs. If expenses are extraordinary and nonrecurring, there will be a greater chance that they will be considered capital expenses (Encyclopedia Britannica
(7th Cir.))
(3) Future Benefit Test: Not all expenditures that produce a future benefit must be capitalized (e.g., advertising
is not capitalized)
(4) Separate and Distinct Assets: Future benefit isnt controlling. Neither is separate and distinct asset, but its
a pretty good sign that capitalization has happened. (Lincoln Savings)
INDOPCO (U.S. 1992)
Natl Starch is being taken over in friendly takeover. They want to deduct expenses incurred during the
takeover.
To be capitalized, expenditures must be either: (1) For a separate and distinct asset (Lincoln Savings)
or (2) for realization of significant future benefits beyond the year in which the expenditure is
incurred.
Post-INDOPCO, the service issued regs saying:
Employee training costs are still deductible (unless its a manual that will be used for years)
Advertising costs are deductible (unless its a billboard that will be used for years)
Hostile Takeover Cases (Post-INDOPCO)
Stanley: Costs incurred to defend against hostile takeover are deductible (i.e., dont need to be capitalized)
Dana Corp: Involved $100K retainer fee paid to Wachtell to be certain Wachtell cant represent a hostile
acquirer. In a year, the company applies the retainer. Court holds that the company has to allocate the $100K.
Part used to prevent a hostile takeover is deductible; part used in conjunction with a friendly takeover is
capitalized.
Wells Fargo: Norwest had been looking for banks to buy. Found one, arranged to buy. Court says: Different
treatment of investigatory (deductible) vs. post-final decision (capitalized) expenses.
o *Note: Once youve picked the bank youre going to buy, what do you capitalize?
(1) External costs but not internal
(2) Direct costs but not indirect
Direct: materials, wages of Ees who produce or sell goods
Indirect: Costs of repair, maintenance of equipment, facilities, utility costs, rent on
equipment/facilities/land, etc.
(3) Origin of the claim (test for legal fees)
Ongoing Expenses
PNC (3d Cir. 2000)
Banks seek to deduct the internal and external costs that they incur in connection w/issuance of loans to their
customers. Should they be capitalized? Tax court says yes. [*In the past these would not have to be capitalized
but, post-INDOPCO, the IRS started going after them.]
Held: No. Costs incurred in connection with the banks loans to customers are ordinary and necessary
expenses and should be deductible.
Routine costs do not have to be capitalized, even if they go toward producing long-lived assets.
Ordinariness is more important.
Post-PNC, the IRS issued a series of rulings:

34

Separate and distinct asset defined: property interest of ascertainable and measurable value, protected under
law, that can be sold, transferred, etc.
o Mortgages are separate and distinct assets (contrary to PNC)
No capitalization of employee compensation
Rejected a regular and recurring rule
They give a lot away in the regs: bonuses, fixed overhead, $5K de minimis rule

Start-up Costs
General rule under 162 is that start-up costs are not deductible.
195: allows TP to deduct up to $5K of start-up expenses in the year the business begins. Deduction is phased
out and eliminated if expenses exceed $50K. Remaining expenses deducted over 15 year period; expenses to
purchase intangible assets of an existing biz can be amortized over a 15 year period.
Start up expenditure means:
o (1) Any amount paid or incurred in connection with:
(i) Investigating the creation or acquisition of an active trade or biz; or
(ii) Creating an active trade or biz; or
(iii) Any activity engaged in for profit and for the production of income before the trade or biz
actually begins, in anticipation of such activity becoming part of the trade or biz; and
o (2) Would be deductible if for an existing trade or biz
Investigatory expenses get amortized under 195, but those that actually facilitate the acquisition have to be
capitalized
Deductible Repairs
General Rule: If merely repairing property, then its deductible. But if youre improving the property, then
you have to capitalize under 263A.
Airline Regulations
(1) Situation 1 Deductible
o Normal heavy maintenance visit
(2) Situation 2 Part deductible, part capitalized
o Same heavy maintenance visit, but also replaces the skins on part of the plane, installs some new
smoke detectors, etc.
Normal stuff is deductible, but the skins and putting in new features is not
(3) Situation 3 Capitalize
o Much older aircraft (22 years old). Substantial improvements w/purpose of extending its life

Reeds framework for thinking about this:

o Aircraft is supposed to have a 15-year life. Originally worth $15 mil. We expect it will have some pattern
of decline over time. Well take depreciation thats something like that pattern (so our basis in the asset
will look something like that pattern).
o How to think about these repairs: Theres some overall pattern of depreciation that were assuming. The
reality is that what repairs are doing is keeping you along that original path.
*Contrast the box-car example where if you rebuild the boxcar every few years you put it on
a whole new trajectory.

Environmental Cleanup
Rev. Ruling 94-38: soil remediation expenses need not be capitalized b/c they merely brought the land back to its
state before the contamination; BUT, the costs of constructing groundwater treatment facilities, however, had to be
capitalized.

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Why is this right?

Think of it as a matching issue: to what income should this expense be matched?
o Matched to past income I should have deducted some of this cost 20 years ago. No reason to capitalize
it now. Cleaning up the past mess should be related to past income.
Cleanup relates to past income capitalized
o Basis If I bought land for $1mil, my basis is $1 mil. If land is now worthless, I have a mil basis in land
and FMV of 0. If I spend $1 mil to clean it up and capitalize it, I have $2 mil basis and land worth $1 mil.
But if I dont capitalize it, I have a basis of $1 mil and land worth $1 mil. Thats the right result.
o Containment: relates to future income, so capitalized.

Job Search and Education Expenses

b. Job Search

Rev Ruling 75-120

o Job seeking expenses are only deductible for same T/B
o Not deductible for 1st time or after too long a time
What is a new T/B?
Expenses of Seeking Public Office
o Cant deduct assessments paid to a political party in order to gain the support of the party
o Cant deduct legal fees and other expenses in connection w/hearings for confirmations
c. Education Expenses - Reg 1.162

Reg. 1.162-5(a)(1) Education expenses are:

(1) DEDUCTIBLE as ordinary and necessary if:

(c)(1) Maintain/Improve skills

o Skills maintained/improved must be skills required by the individual in his employment
o Includes CLE courses, refresher courses, etc.
(c)(2) Meet requirements of employer or applicable law/regulations
o Must be incurred for retention of employment relp, status or rate of comp
o Has to be for a bona fide business purpose
o CLE also qualifies
and if the educational expenses dont fall under the non-deductible sections.
(2) NON-DEDUCTIBLE as ordinary and necessary if:
(b)(2) Minimum Educational Requirements
o (i) Expenses incurred to meet minimum educational requirements necessary for qualification in
employment in a trade or biz
Determine what these reqts are by looking at reqts of employer, applicable law,
standards of the profession, etc.
Already acting in the job status does not mean you have met the minimum requirements
(examples are MBA, bar admission)
Note: If faculty member, presumed to have met min. educational reqts
o (ii) Teachers/Higher Education
(b)(3) Qualifications for new Trade or Business
o If the education qualifies you for a new trade or business, not deductible
o A mere change of duties doesnt count as a new trade or business (applies to all teaching duties)
must prepare taxpayer to perform significantly different tasks and activities than could be
performed before the education (McEuen)

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Intent to pursue the profession/whether you do pursue the profession doesnt matter. All that
matters is that the education could lead you to qualify for a new trade or business (ex: cant say
that your JD doesnt qualify you for a new trade or biz b/c you havent passed the bar)

Wassenaar (T.C. 1979)

Wassenaar graduated from law school in 1972 and went on to get his masters in tax. Graduated in 1973 and
returned to Detroit to work at a law firm. Tried to deduct the costs of his tax degree as an employee biz
expense. Held: Not deductible. His prior work experience does not have a proximate relationship to the
education expenses. He has not yet passed the bar, so not yet working as a lawyer.
A law student who gets an LLM prior to being admitted to the bar/working as a lawyer does not
meet the requirements of 1.162 and cannot deduct the LLM expenses.
McEuen (T.C. 2004)
TP is an ibanking analyst. Would need an MBA to become an associate. She gets an MBA, goes to a new job.
Tries to deduct MBA. Held: Not deductible b/c disallowed under both disallowance tests.
Just b/c she was doing associate level work does not mean that the MBA was not required. It also
qualifies her for a new T or B, even if she doesnt pursue it.
Zhang (T.C. 2003)
TP is a consultant. Gets an MBA and then a new job as an ibanker. Held: MBA is not deductible b/c it does
not: (1) maintain or improve skills; or (2) is not expressly required by the employer or applicable law.
Hard to argue that an MBA will ever meet the reqts of an Er unless you worked there before and are
committed to working there after.
Code Provisions
222: Qualified Tuition and Related Expenses
Above-the-line deduction under 62(a)(18) [which allows deduction for 222
Qualified Educational Expenses: tuition/fees [222(d)]
Max: $4K for college tuition and related expenses for self, spouse, or dependent
Cliff Effect [222(b)(2)(B)]
o AGI:
0-$65,000 up to $4K
$65,001 $80,000 up to $2K
$80,001 + not eligible for deduction
25A Hope and Lifetime Learning Credits
Hope Credit:
o 100% of qualified educational expenses not exceeding $1K (in the taxable year) and 50% credit on the
next $1K [25A(b)(1)]
Total: $1,500
In 2009 and 2010, there were special rules/bigger credits [25A(i)]
o Limitations [25A(b)(2)]:
Only allowed for 2 taxable years, and only allowed for the first 2 years of post-secondary ed
(can be claimed no more than 2x per student)
At least time student
No credit if student convicted of felony drug offense
o Allowable credits are adjusted for inflation [25A(h)]
Lifetime Learning Credit:
o 20% of qualified tuition/related expenses paid by taxpayer not exceeding $10K (in the taxable year)
[so, max of $2K]
Can be used for undergrad or grad education at any point in taxpayers, spouses, or
dependents life

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Can be used for students attending school at least half-time or taking courses to acquire or
improve job skills
Not available to anyone who doesnt owe taxes (so, low-income)
Both credits cant be taken for the same student in the same year
Qualified Educational Expenses: Tuition and fees required for enrollment of the TP, TPs spouse, or any
dependent of the TP
o Reduced by scholarships that are excluded from income, and certain forms of educational assistance
Dependents cant get the credits
Linear Phaseout for AGI between $40K and $50K for singles ($80K and $100K for joint filers):
o Amount taken in 25A(a) = H+L. This shall be reduced by X.
(H+L)-X = credit
To calculate X, use this calculation:
X/(H+L) = (AGI - $40K)/$10K
o If you have a salary of $50K:
(50K- 40K)/10K
10K/10K = 1
1 = X/(H+L)
H+L=X
So, no credit allowed. ($0)
o If you have a salary of $45K:
(45K-40K)/10K
5K/10K = .5
.5 = X/(H+L)
X = 50% of the credit, so you only get to keep half your credit ($1K)

529 Qualified Tuition Programs

Contributor can either (1) purchase tuition credits or certificates on behalf of a beneficiary or (2) make
contributions to an account that will be used to pay qualified higher education expenses No taxes on
distributions for educational expenses
Can be used for room and board
Contributions arent deductible but earnings are exempt
Distributions are excluded by beneficiary to extent of the beneficiarys qualified tuition expenses
o 10% penalty if you use the money for non-educational purposes
529 Coverdell Savings Account
Contributions are not deductible but earnings are tax exempt
Distributions are excluded by beneficiary to extent of the beneficiarys qualified tuition expenses
o 10% penalty on distributions if used for something other than qualified education expenses (with some
exceptions)
Max contribution: $2K each year
Includes primary education
Phased out from $95k to $110k
117 Qualified Scholarships
Tuition, fees, books, etc.
Cant be compensation for teaching (grad students)
Cant be conditioned on performing services (w/2 exception)
o So athletic scholarship $ is excludable if the $ doesnt required the student to play a particular sport,
doesnt cancel if student drops the sport, etc.
127 Educational Assistance
Er pays for educational assistancenot included

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Max exclusion is $5,250/yr

Has to be non-discriminatory
Stock restrictions
Cant provide choice between educational assistance and the cash

221 Education Loan Interest = Deductible

ATL deduction up to $2,500 (b/c 62(a)(17) allows for interest on education loans)
Phased out from $50k to $60k (adjusted for inflation)
Dependent cant take the deductionparent does
Must be incurred to pay for college for TP, spouse or dependent who is in school at least time
135 Savings Bonds
Tax free if used for education
Depreciation and Amortization
Generally
167: permits you to depreciate for wear and tear when involved in a trade or biz and held for the production
of income
167 tells you how to depreciate intangible assets
168: tells you how to depreciate tangible assets

Deduction designed to allow TPs to treat as expense in determining taxable income in allocable part of cost of
biz or investment assets that have limited life
Can never depreciate property used for personal purposes

Depreciation Methods
(1) Economic depreciation this is the ideal, neutral as to asset choice; simply measures true decline in the
value of an asset over the course of a year.
o Would be administratively infeasible.
(2) Straight line method cost of an asset is allocated in equal amounts over its useful life.
o Estimate useful life of asset, determine cost of asset, subtract salvage value which will receive at the end
and divide that amount by the useful life.
o Rate of depreciation under straight-line is the reciprocal of the useful
(3) Declining Balance method (a type of accelerated depreciation) allocates a larger portion of the cost to the
earlier years and a lesser portion to the later years; constant percentage is used, but it is applied each year to the
amount remaining after the depreciation of previous years has been charged off
o Double Declining Balance take twice as much percentage each year; take 200% of what you would
otherwise get of straight-line method and then apply declining balance method
o Inflation problems can justify using accelerated depreciation because if inflation after year of purchase,
value of depreciation deduction will decline over time.

Cant depreciate until actually put into use

Congress has never made companies switch systems after statutory changes so there are multiple methods in
use right now
Only owner can depreciate the owner is the one who enjoys economic benefits and bears the economic burden
of decline

Modified Accelerated Cost Recovery System [168]

Depreciable assets are assigned to one of eight recovery classes w/lives of 3-39 years
o See 168(e) for classification

39

Need to find:
o Applicable Recovery Period
o Applicable Depreciation Rate
o Applicable Convention
Step 1: Classify the property under 168(e)
Step 2: Figure out the applicable recovery period under 168(c)
o Same as useful life of the property (recovery period for automobiles is 5 years, but youll be taking
depreciation over 6 years b/c of half year convention)
Step 3: Figure out the Depreciation Rate under 168(b)
o 3, 5, 7, and 10 year classes = start w/ double declining and then switch to straight line when that starts
producing larger deduction.
168(b)(1): start depreciating by double-declining balance then taxpayer switches to straight
line method that allocates cost ratably over the remaining recovery period in year which that
method produces a larger deduction
o 15 and 20 year classes = depreciated using 150 percent declining balance method, with switch to
straight line method in year straight line recovery produces a larger deduction
168(b)(2). permits full recovery of basis.
o Non-residential real estate: 39 years and straight line depreciation (168(b)(3)
o Residential real estate: 27.5 years and straight line depreciation
o Election to use straight line = Taxpayer may elect to use straight line in any class of property (168(b)
(3)(d) and (b)(5)
but you cant cherry-pickhave to do election for whole class of assets
election is irrevocable
o IN ALL CASESsalvage value not taken into account (168(b)(4))
salvage value = amount taxpayer would expect to recover when he stops using the asset for
production of income
o Tables show depreciation schedule for various assetsdont have to calculate it. Table on page XV
o If no special rule for the assetlook at 168(e) and see what the class life by old tables is equivalent to for
new tables.
Step 4: Look at 168(d) to figure out the applicable convention
o 168(d): personal property half-year convention = one-half years depreciation is allowed in both year
of acquisition and disposition, regardless of how early or late in year taxpayer got or sold the property
Provides advantage to purchase property late in the year
Treated as if you put it into service halfway through the year; therefore, you get only 6 months
depreciation in the first year. So, if youve only gotten 6 months depreciation the first year
and you have a five-year asset, youhave to take 6 years total to depreciate (but 2 of them will
be half year)
o 168(d)(3) mid-quarter convention if more than 40% of purchase of depreciable property placed in
service in the last quarter of the yeara mid-quarter convention appliesproperty deemed purchased at
mid-point in quarter
o Real Propertymid-month conventiontaxpayer takes one half a months depreciation for month of
acquisition and disposition. (168(d)(2)); reason = its bigger transaction and you dont do it as much so
not burdensome to apply

Miscellaneous Depreciation Issues

Recapture: 1245 and 1250 provide that certain amounts previously deducted as depreciation will be recaptured
as ordinary income rather than CG when depreciable property is sold.
o 1245: Recharacterizes as ordinary gain the portion of any gain on the sale of depreciable property that is
attributable to having taken depreciation deductions. E.g., If property acquired for $1K is fully
depreciated, then sold for $1200, TP will realize $1K of ordinary gain and $200 of CG
o 1250 (real property): You only have to recapture to the extent that youre depreciating faster than straight
line. But the rule for real property is straight lineso youve never been depreciating faster than straight

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line. You recapture 0. Gain up to the amount of depreciation allowed on real property held for more than
12 months is taxed at special CG rate: 25%

Land
o Cannot depreciate. If you buy land + building, have to allocate in proportion to the respective FMVs
Improvements to Property
o Depreciate like the underlying property but you start on the day you actually perform the service
Intangibles
o 168 only applies to tangible assets
o 197 allows for amortization of most intangibles (including goodwill, old subscriber list, etc.) can be
amortized on a straight line basis over a 15 year period; doesnt apply to any intangible created by TP
unless in connection w/acquisition of indebtedness)
179
o Exception to 168. Allows you to deduct immediately up to $125K of cost of tangible business property
where annual total investment in qualified property is less than $500K.
168(k) Bonus Depreciation: allows you to write off a portion in the first yearbonus depreciation is currently
100%, so youd always elect bonus depreciation instead of 179
Luxury Cars
o 280F limits amount of depreciation that can be taken on luxury automobiles

Depletion

Ex I buy land for oila wasting asset. Lets say there are 1 mil barrels in the ground. If you pull up
100,000 barrels this year, you will amortize 1/10th
o Sensible system with a couple of caveats.
We dont require you to capitalize a large portion of the costs that should be capitalized
Buy the rights capitalized
Build a rig capitalized
Pay workers/buy supplies normally those would be capitalized, but youre allowed to
expense those intangible drilling costs.
o Percentage depletion
Ex. Depletion deduction is 11% (or some arbitrary percentage) of your incomehas
nothing to do with how much youve used up the asset.
Interest

In General and Arbitrage

General Rule: If you borrow money, thats not income. When you pay interest, it should be deductible.
Problems with Interest
(1) What is interest and what is principal? (problem in pure cash transax)
(2) Identifying whether something is debt or equity (arises in corporate tax scenario)
(3) Arbitrage Problem (fundamental problem)
o Using debt to buy something that gets immediately expensed (e.g., borrow $1K to buy a govt bond,
receive 10% interest on the bond. Pay 10% interest on the debt and receive 10% incomecancels out.
o Using loan to buy stock that doesnt pay dividends; allowing deduction on interest and get to expense it
(e.g., I borrow to buy stockits not expected to pay dividends. I just am hoping for appreciation. You
shouldnt get an interest deductionincome is deferred and taxable at a lower rate!)
Business Interest [163(a)]
Generally deductible except when you have to capitalize it (e.g., when allocable to an asset that TP is
constructing)

41

Must be properly allocable (i.e., tracing)

Investment Interest [163(d)]

Investment interest is interest on indebtedness properly allocable to property held for investment
Deduction of interest on debt incurred by individuals to purchase or carry investment property is limited to net
investment income (with indefinite carry-forward of interest disallowed under this provision).
163(d)(3)(A): links debt with activity so properly allocable to property held for investment. Matches
investment expenses to investment income (doesnt work perfectly)
163(d)(4): Net investment income is total investment income less investment expenses.
o 163(d)(4)(B)(iii): gives you the option to recharacterize capital gains as ordinary investment income.
Pro: allows you to increase the amount of investment income against which you can match
investment interest.
Con: cannot then claim preferential capital gains tax rate on the amount elected. 1(h)(2).
o So if you borrowed to finance investments but your portfolio did poorly, you cannot generate a loss -the best you can do is have no tax on your investment income.
Interest incurred in connection with passive activity is not treated as investment interest, but is instead subject
to the rules of 469 which limit deductibility of passive losses.

163(d) says dividends are not included in investment income unless taxpayer elects to include them and forgo
the preferential capital gains treatment
Dividends cannot offset losses this changes your calculation
The way this can help you have net income of $0 and lots of business deductions you can take advantage of
carry-forward rule by including dividends in investment income
At what point can you get around 163(d) by saying you are in a business and thus deducting under 162? Three
categories (Yeager):
o Investors: not in the trade or bizthey get cap gains; typically hold stock for long periods of time;
subject to 163(d)
o Traders: someone who is trading so actively that they are in the T or B of trading stockthey get cap
gains; not subject to 163(d) so they get the deduction
o Dealer: they do not get cap gains; not subject to 163(d) so they get deduction
Dealer sells to customers; trader sells to market

Personal Interest [163(h)]

In general, no deduction for personal interest
Personal interest includes all interest except: biz interest, investment interest, passive gains, home mortgage
interest, student loan interest
Business of being employee is totally disallowed
o Ex: Er requires you to provide a car for your biz. If you borrow to buy that car for your biz, no interest
deduction.
Home Mortgage Interest Exception [163(h)]
Major exception to the disallowance of personal interest deductible
Doesnt matter if the debt is recourse or non-recourse
Allows for 2 types of deduction:
o Acquisition Indebtedness: interest deductible on up to $1M of debt used to acquire, construct or
substantially improve either principal residence (sale of principal residence = no tax on gain under
121) or second home (sale = tax on gain under 121), debt must be secured by the home (cant take
out loan on 1st home to buy 2nd 2nd home must secure 2nd loan)
Acquisition must be secured, used to acquire, up to $1M (not indexed)
Limit reduced as principal is repaid on loan and refinancing does not increase (163(h)(3)(B))
Applies to the first refinancing and any subsequent refinancing (163(h)(3)(B))
Dont use the properly allocable testits much looser

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Secured by the residence is a major requirement has to be secured, and has to be secured
by the home youre actually acquiring.
Home Equity Indebtedness: interest may be deductible on home mortgage equity
indebtedness up to $100K, regardless of purpose or use of loan, as long as debt does not
exceed FMV of home, must be secured by residence but up 100k can be used for
anything. 163(h)(3)(C)
Must be secured
Limited to the difference b/w FMV of the home and other acquisition indebtedness I have
Limited to $100K
Home mortgage interest trumps investment interest!
o Hypo: I borrow $80K secured by a home. No other debt. I use it to buy stock. It is investment interest,
but its also HE interest. You can deduct.
Has to meet test of 280Ause as dwelling unit

Sham Transaction and No Economic Purpose Doctrines

Knetsch (U.S. 1960)
Practice to borrow to buy an annuity. Borrows @ 3.5% and the return on the annuity is 2.5%. Seems like a
bad deal. But it works out b/c of timingprepays interest on the loan and took immediate deductions. Each
year thereafter, the annuity grew by $100K and he borrowed back $99K to prepay interest and deduct it. IRS
was generally fine w/this until San Houston sets up a business to do only this.
If the only purpose of the transaction is to get tax deductions, the transaction will not be upheld.

Congress has since enacted 264, which says you cannot deduct interest used to purchase single premium
annuity contract. This kills the loophole Knetsch tried to exploit.

Goldstein (2d Cir. 1966)

G won $140K. This put her in a higher tax bracket. Her son advises her to: borrow at 4% from bank (prepaid
interest) and loans it to the fed govtshe buys treasury bills at 1.5%. Bonds were security for the loan. Now
you have a different deal: bona fide loan with the bank, asset is now an interest of the fed govt.
Purpose is clearly only to get a deduction. With interest, you need some motive other than taxes for
the transaction.
What is Interest? Problems with Inflation

o
o

o
o

d. Inflation
Inflation causes bracket creep any times here is a fixed $ amount in the code it changes every year b/c of
inflation. So you will get to a higher bracket sooner, or will phase out of a benefit sooner. Solution is easy,
just index the numbers.
But w/assets or liabilities we have a different problem.
What is a payment of principle and what is a payment of principle?
If you bought your asset w/ $1k and now its worth $1.4k, I dont really have a $400 gain b/c of
inflation. Wrong to say that my gain is $400.
We systematically overstate the income on assets
W/debt we have the same problem.
W/inflation you are in effect deducting principle
If I borrow $1,000 and later I pay you back $100, have I really paid you back 10%?
Lots of pressure to index the basis of capital assets for inflation. But weve never done it.
Is it important to correct it for debt?
No b/c there are two sides to the txn.
If people have the same tax % on both sides then the mistakes offset.
But this is unrealistic. Would lead to inequities between high and low bracket tax payers.
But in practice it is very difficult to index.

43

 Also no one is arguing for indexing debt b/c that would smaller deduction. (Unlike indexing
income, which would lead to less reported income, so it is more popular.)

o
o
o

e. Other payments w/respect to loans, especially fees

When you borrow money, there are other fees like credit checks not interest, not deductible.
If they bake it into the interest rate, then its fine. But if not, its not.
Grey areas
Late charged for utilities. IRS says this is interest.

Losses
I.R.C. 165 LOSSES
(c) LIMITATION ON LOSSES OF INDIVIDUALS.In the case of an individual, the deduction
under subsection (a) shall be limited to
(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though not connected with a T/B; and
(3) except as provided in subsection (h), losses of property not connected with a T/B or a
transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty,
or from theft.

Hypo: Can you take a loss on your car?

o You bought it for $10k. A few years later it is worth $6k. You cant take a loss. Personal losses arent
allowed per 165(c).
o But if the car was destroyed suddenly thorugh an accident, you could take a casualty loss.
o 165(h) places limitations on casualty losses.
Hypo: My car has depreciated over time, and then was in an accident. How much loss can I take?
o See Reg. 1.165-7: Lesser of FMV and Adjusted Basis.
Hypo: You have a painting that has appreciated from $10k to $100k. It gets stolen.
o Your loss is only $10k b/c there has not been a realization event.
Hypo: I purchase a building for $100k. I depreciate it to $60k. FMV goes up to $150k. There is a fire. I get
$50k from the insurance co.
o W/o insurance your loss is your adjusted basis =$60k. B/c of insurance, you only get a $10k loss.
CASE Fender v. US (5th C, 1978)
(388)

FACTS / PROC HISTORY: TP sets up trusts for his kids (trying to shift income to them.) He
has significant capital gains, so wants to take a loss. He sells some stock that has gone down in
value to a bank he partially controls, plan is to buy the stock back a little while later.
HOLDING: Motive of tax avoidance alone is not enough. But court is also concerns about
control. Because of the structure of the transaction (dominion over bank), the taxpayer
retained sufficient domain over bonds to ensure that he could recapture them and not suffer
economic loss.
RULE: To take loss deduction, TP must show that loss was incurred by a bona
fide sale (substance, not form). Reg 1.165-1(b).

Is Fender right?
o He sold the stock for 42 days, longer than the 30 day limit in 1091 (Wash sales rule).
o Shouldnt the TP be able to rely on 1091?
o See also 267 related party sales. Fender owned 40%, so not related party.

44

See also Dupont Case

o Dupont wants to privately sell some bonds. Doesnt want it to be public b/c of the depression.
o He and a friend sell each other their portfolios privately.
o Court disallows the loss.

Capital Losses:
o 165(f) only allows you to take losses as permitted by 1211 and 1212
o 1211: capital losses deductible by corporations up to capital gains; by individuals only to
extent of capital gains plus $3K ordinary income
o 1212: any capital losses not allowed in current year may be carried forward indefinitely by
individuals
o Why do we have a capital loss limitation?
the problem is TP have ability to select the timing of gains and losses
w/o capital loss limitation, TP could realize all losses while holding off all their gains
163(d) (interest limitation) and 1211 prevent this
w/o these provisions, well-advised TP would never pay taxes -- would buy a
big portfolio of stocks and use losses to offset all capital gains

Related Party
o 267: disallows deductions for losses from sales or exchanges of property, whether direct or
indirect, between certain related people, such as family members or corporations and majority
(>50%) shareholders
o sellers loss is generally lost permanently under this provision b/c purchasers basis for
computing loss when sells property is his cost
o if ultimately sells property for gain, purchasers cost basis is increased by sellers disallowed
loss. 267(d)
o use of intermediary does not change treatment.
o Reasons for 267?
Really not a realization event b/c havent really disposed of it if still in family or sold
to corporation they own
Dont trust the valuation could be part sale/part gift.

Wash Sales
o 1091 (Wash Sales) -- disallows loss from sale preceded or followed by purchase of
substantially identical securities (including options) within 30 day period (look up/back 30
days)
o old basis, adjusted by the price difference (New Basis = Old Basis + Change in Price (or, in
other words, New Basis = Cost + Loss))
o only to applies to losses
o Only covers securities, not all assets.
o Really requires that securities be identical to be caught in the wash sale provision.
Does not apply to bonds with different issuers.
o covers a 61 day period (day of sale + 30 days before + 30 days after)

Bad Debts

BusinessBadDebt
o 166(a)Abusinessbaddebtisdeductibleinfullasanordinaryloss.
(1)whollyworthlessdebt:cantakethededuction
(2)partiallyworthlessdebt:candeducttotheextentchargedoffbytheTPon
thebooks

45

NonBusinessBadDebt
o 166(d)(1)anindividualmaydeductawhollyworthlessnonbusinessbaddebtonlyas
ashorttermcapitalloss
o TPspreferbusinessbaddebtovernonbusinessbaddebt,asthelattermayonlybe
deductedascapitallossandonlywhenworthless

mustbebonafidedebtadebtorcreditorrelationshipmustexistbasedonavalidand
enforceableobligationtopayafixedordeterminablesumofmoney.Reg.11661(c).
nobasketrulecanoffsetothergains
nodeductionforclaimsforunpaidsalaryorrent,b/csuchdebtshavezerobasisb/cifpaidthey
wouldbeincludedinincomeandtaxed;thefactthattheyarenotincludedinincomeandtaxedis
treatedfavorableenoughtreatment.

Timing
o 166(a)allowsadeductionfor"anydebtwhichbecomesworthlessw/nthetaxableyear"
o presentsthedifficultquestionofdeterminingtheyearinwhichthedebtactuallybecame
worthless
o 6511(d)providesaspecialsevenyearstatuteoflimitationsw/respecttorefund
claimsbasedonthedeductionofbeddebts

DominantBusinessMotivation
o thequestionwhetherabaddebtresultedfromaloanmadeforadominantbusiness
motivetypicallyturnsontheparticularfactsandcircumstances,whenbothinvestment
andbusinessreasonsarepresent.
o Hypos:
Easycases:
Isetupabusinessmakingcarloans.Allthoseloansarebusiness.
Isellcarsandtakebacknotesfrommycustomers.Business.
Imbothaninvestorandemployeeofacorp.Iloan$tothecorpandthenit
goesbad.
Iclaimitsbusinessb/cIloanedittoprotectmyjob.
Orisitpersonalb/cImjustaninvestor?
Test:dominantpurposemustbebusiness.Cantjustbeoneofthe
purposes.
o Tradeorbusinessoflendingmustbeextensiveevidencethatlendingisactually
taxpayer'stradeorbusiness
o EstateofBoundsv.Comm(TCM1983)mustnotbeintermittenttransactions,but
extensiveandcontinuous
courtlooksatalltherelevantfactorsincludingtimespentonlending,passive
contact,advertising,maintainingaseparateoffice,bookkeeping,occupation
listedontaxreturn

Definition -- an aim to generate losses that can offset or shelter other income, such as wages,
interest, or dividends that were neither produced by nor related to income produced by investment.
Under general rules, losses can offset other income
o Estate of Franklin- example. Doctors buy hotel that will generate losses from interest
deduction and depreciation, will use to offset income.
Caused by failure to index certain parts of the Code to inflation

Tax Shelters

46

Mostly a problem of mismeasurement of income: If allow deduction for prepaid interest,

accelerated depreciation, dont take inflation into account, then openings are created for
abuse
Often passive investments, and often structured as limited partnerships to provide investors both
the benefits of limited liability and conduit taxation (whereby income and losses of partnership are
passed through to partners). [469]
May either be legitimate sometimes intentional on the part of Congress (accelerated deductions
for real estate to encourage real estate investment) -- or abusive.
Not all tax-shelters as business activity structured to generate loss to offset income:
o Charitablebuy gems wholesale and donate to Smithsonian and claim full price
deduction
Personal Deductions

Standard Deduction

Taxpayers may either itemize or take a standard deduction [ 63]

Why have a standard deduction?
o (1) To provide a baseline under which people dont pay tax
o (2) Simplification
Currently, the standard deduction is $11,600 for married filing jointly; and exactly half that for single
individuals)
Children are generally treated as separate TPs they get reduced std deduction (capped at greater of $950
or earned income + $300). No personal exemptions.
People who take standard deductions cant deduct charitable contributions

Personal Exemptions and Credits

You get an exemption for self, spouse, dependents
o Who are your dependents?
152: dependent is either a qualifying child or a qualifying relative
Qualifying child/relative need not be child/relative!
If you are yourself a dependent, you cant have further dependents
Qualifying Child:
o Relp (child, bro, sis, stepbro, stepsis, any descendant of the aboveso, brother,
nephew, etc.)
o Principle Place of Abode (must share same principal place of abode for half the year)
o Age (18 or under, or student under 24; age test is ignored if youre disabled)
o Support (individual cant provide more than 50% of own support)
Qualifying Relative
o Support (you must provide more than 50% of the support)
o Relp (includes parents and other ancestors; also includes individual who is a member
of the household and has same principal place of abode)
o Gross income test (must be under the exemption amount in 151(d)so has to be very
low income)
Phaseouts of Exemptions and Itemized Deductions
o 151(d) PEP (personal exemption phaseout)
o 68: 3% Haircut (phased-out itemized deductions)
Gets Congress the revenue without being obvious about it
o Bush tax cuts phased out the phaseouts.
o For 2011-2012, there is no PEP and 68, but theyll be back in 2013
o How they worked:

47

151(d): Every time you earned another $2500 over $150K, you lost 2% of your exemptions. The
more kids you had, the higher the tax you had!
Take the amount you are over, divide by $2500, multiply by 2%. That is the amount youll
lose from the exemption.
Subtract that amount from personal exemption to determine amount of exemption you can
take.
Multiply that amount by the marginal rate and divide the result by the amount you are over
to determine increase on marginal rate due to phase out.
68: For most individuals, it had no effectso $1 itemized deduction still reduced taxable income
by $1. Effect was simply to put a surtax of about 1% of income. It was only for people whose
income was relatively high compared to deductionsrare cases. In those cases, $1 itemized
deduction only reduced taxable income by 20 cents.

24 Child Credit
$1000 (not indexed)
Partially-refundable:
o You can get up to 15% of your earned income over $3K
o Seen as an expenditure (welfare)youre not reducing taxes, but giving $ to people who dont pay
taxes
o People w/income up to about $47K dont pay income tax (family w/2 kids) half the ppl in the
country
32 Earned Income Tax Credit
o The more income you have, the more income maintenance you get
o History
Thought of as an offset for payroll tax to working, low-income individuals
Dealt with the concern that general welfare programs discouraged work
o How it Works:
If 1 qualifying child, 34% tax credit (for every extra dollar you earn)
If 2 qualifying children, 40%
At some point, you hit the max credit
Ex: Max credit for 2 children: $5,028
Ex: Max credit for 1 child: $3,043
Ex: Max credit for no children: $457
Phase out percentages 32(b)
If you have no children: 7.65%
One child: 16%
Two children: 21%
o Incentives to work more or less vary depending on where you are (how much credit you get) If the
credit is minimal, you have incentive to work less.

48

Personal Itemized Deductions

Taxes 164
Allows certain taxes which are otherwise personal to be deductible anyway (property taxes, state & local
income taxes)
o Sales tax used to be included on this list but 1986 Act took it awaystates were pissed b/c if state
made all its money off of sales tax, this pissed it off. So:
o 2003: Provision was included saying you can either deduct sales tax or income tax
o Certain taxes have to be capitalized
Taxes associated with acquisition of property
Under 263A, taxes are one of the items that sometimes have to be capitalized
o Certain taxes are never deductible
Fed income tax
Estate taxes
Employee portion of payroll taxes
o Certain taxes are credited
Dollar for dollar deduction in tax liability b/c you paid other taxes foreign taxes
If you earn income abroad and are taxed on that income, the portion that is taxed is a
credit for U.S. Idea is to protect the domestic tax base
Mainly relevant for corporations, not individuals
213 Medical Expenses
Generally deductible under 213.
Only deductible that it exceeds 7.5% of AGI. As a part of health care reform it will go up to 10% in 2013
If you have Er provided insurance or if you buy insurance, it will be excluded. If you dont have insurance,
and pay med expenses, it wont be deductible unless it exceeds 7.5% (soon 10%) So, substantial
incentive to buy or have Er-provided health insurance.
Law is that you can deduct them right away
170 Charitable Deductions
General rule: gifts to charity are deductible (170(a))
Charitable contribution defined: donation to corporation, trust or comunnity chest, fund, or foundation
organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, etc.
(170(c))
Limited to a % of your income (50%)
If gift of appreciated property, limitation is lower (30%)
To extent its to a private foundation, limit is even lower (20 or 30%)
What is the difference between public charity and private foundation?

49

o Public charity is dependent on the public for its funding (Red Cross, Art museum)
o Private foundation does not have to answer to the public, only to the donor (Gates foundation)
o Congress is more suspicious of private foundations b/c they have less public oversight.
Why should we give a deduction?
o Two theories
(1) Its not your income anymore. You gave it away, you cant consumer it. Appropriate
to remove it from the tax base.
But we might feel differently based on the use of the funds. Different to give $
to a soup kitchen than to give $ to the opera, which you regularly attend.
(2) Subsidy a way for the government to subsidize charitable activities.
Kind of like a matching gift program.

What issues arise?

o What if you get something in return, like a tote bag when you donate to NPR?
If the tote bag is worth $15 and you donate $100 you only get an $85 deduction.
This rule is difficult to operationalize.
When you donate money to the law school and they name something after you are you
getting something in return? Legal answer is no.
o Hernandez case
Doctrine of reciprocal exchange (you have to pay for religion)
IRS goes after scientology.
Court says they are getting something in return.
Dissent how do you value the exchange? We know what tote bags are worth. We dont
want the courts valuing religious benefit. So the IRS can either presume the value is what
you pay for it, or presume it is 0. And for other religions, they have presumed the value
is 0 (admissions tickets, pew rentals).
Afterwards, the IRS issues a ruling saying it is deductible. Enter into a secret closing
agreement to the church.
Congress buys the dissents argument. Quid pro quo rules say no value for a solely
intangible religious benefit nor normally sold in a commercial context.
One concern the court has was private religious school tuition Sklar.
o Sklar case
Argues he can allocate btw the secular & religious components of his childrens school.
He subpoenas the closing agreement.
Court orders the IRS to disclose the closing agreement and the IRS refuses.
Court is furious but cant do anything. Rules against Sklar.

Other sections
o 170(f)(8) substantiation requirement
o ? requires written evidence over a certain amount
o Provisions dealing w/various scams
Gifts of services cannot deduct the value of your services
Donations of private property
o Hypo: Just set up a company and donate some stock.
o Should you get a deduction equal to basis (here its 0) or to FMV?
o Right theoretical answer is just basis. But the law is the FMV.
o 170e cuts back on this rule.
Circumstances now where you only get basis.
If the property generates ordinary income, deduction is limited to basis
If the property would generate short term capital gain basis
If it would generate long term CG may be eligble

50

If to a public charity and if real property FMV

If intagible FMV (big category like stock)
What about tangible personal property (painting, car)?
If related FMV
If not related basis
Example: Giving a painting to the art museum
o It is long term CG
o It is a public charity
o It is real property
o If they are going to hang it in their collection then FMV
o But if they are just going to sell it then basis
Private foundation
o If its qualified stock FMV
o Otherwise Basis
o
o
o

Summary

From Gross Income

(Above the Line)
Trade or business deduction
Reimbursed expenses of employees
Losses
Deduction from sale or exchange of property
Deductible nonbusiness expenses related to
rent of royalty income
Alimony
Moving expenses
Interest on educational loans
Contributions to Conventional IRAs

From Adjusted Gross Income

(Below the Line)
Standard Deduction -- OR
Medical Expenses
Charitable Contributions
Casualty and theft losses
Nonbusiness expenses for property held for the production
of income
Nonbusiness expensesexpenses of a tax-related matter
Other miscellaneous itemized deductions
Home mortgage interest

51

WHOSE INCOME?
Personal Itemized Deductions
Treatment of Couples

52

Possibilities:
o Even earners or uneven earners
Box A: 100, 100; Box B: 200, 0 (2 people each earning 100k vs 1 person
earning 200k)
We dont want them to have the same liability b/c we believe in the progressive
tax rate
o Even vs. uneven married earners
C: 100 + 100; D: 200 + 0
Should we tax them the same?
Argument that it shouldnt matter: dont look inside the box. Married couple is
a unit.
In D is the stay at home spouse providing services the working couple has to pay
for?
What do we want it to be?
o For penalty: Costs are not always duplicative they save money by being married
o For bonus: We think marriage is a good idea, want to encourage it.

53

But there are conflicting goals here. We cant get all the boxes we want to be the same to
be the same, and yet keep apart the boxes we want to be different. This is b/c of
progressivity.

Historical Practice
o With separate filing system, B > A and D > C.
Started to break down in community property states b/c of jointly owned
property.
In a community property state w/unequal income [D] you were better off than in
a common law state.
No impact on equal earning couples.
Some court case happened, and then states started moving to community
property to lower their residents federal tax burden Geographical inequity
This was a bonus for equal married earners, but not a penalty otherwise.
o Could congress have just ignored community property for tax purposes? Sure.
o So is everyone happy?
Compare [B, 200] vs. [D, 200] The point is there is a singles penalty.
o 1969 Reform
Compromise. Instead of giving the married couple brackets that were twice as
big, they went w/167% This made the marriage bonus (aka single penalty)
smaller.
But this created the marriage penalty.
Compare [A] with [C].
When single they each got a lower set of brackets. Once married they
dont get 2x anymore, now they only get 167% more income taxed
at higher rates.
Relative importance of marriage penalty to marriage bonus will depend on how
many even (getting the penalty) vs. uneven earning (getting the bonus) married
couples.
o So then equal earning couples lobby for reform.
o Reform in 1981 -- Puts in a 10% deduction for a second earner up to a total of $3k.
o 1986 -- Brackets were flattened. If perfectly flat, doesnt matter.
1986 Act reduced the marriage penalty, and eliminated the second earner penalty
went back to smaller brackets + deduction.
o 1990/91 -- Congress introduced a 31% bracket. Clinton increased to 39.6%. Those
changes greatly increased the marriage penalty.
o 2001 -- Eliminated the penalty in the 15% bracket. Put in a new 10% bracket w/no
marriage penalty. Eliminated the marriage penalty in the standard deduction.

Section 1
o Unmarried: 22,100. MFS: 36,900
o @ 15%.
o 36,900/22,100 = 167%
o But shouldnt it be 200%? When Bush made changes didnt rewrite the code. So need to
look for the changes elsewhere.
o See 1(f) phase out of marriage penalty in the 15% bracket. 10% bracket is in 1(i)

Married Filing Separate

o $18,450 half of MFJ
o Generally this is not a good filing status. Basically only use it when you are not speaking
to your spouse, or you dont want to be held joint and severally liable.

Same-sex couples

54

o
o
o

For equal earners, single-sex couples are better off.

But if they are unequal earners, then heterosexual couples are better off.
A gay couple that are equal earners, they would rather be treated as single. If you are
unequal earners you would rather be treated as married.

Hypo: what If wife wants to enter the labor force after having been a stay at home mom for
several years?
o Her income is taxed at 35%. So all of a sudden, they are paying 35% on their first dollar.
o SS payments are first dollar expenses. So they not getting a benefit from SS if your
married and your spouse has been paying into the system you automatically get a benefit
of 50% of their benefit.
o There are examples where you lose money by going to work.

CASE Druker v. Comm (2d C, 1982)

(465)

FACTS / PROC HISTORY: TPS are married couple each w/earned income; challenged
marriage penalty by filing married w/separate return applying rate of unmarried individuals
under 1(c) instead of 1(d)
HOLDING: Rules do not significantly interfere w/decisions to marry/did not deprive
constitutional right; fact of increased taxes places little obstacle on getting married

Treatment of Children

Should the child be treated as a separate independent TP, or should he be part of the family unit?
o Pre-1986 we viewed them as separate TPs, w/their own std deduction and personal
exemption.
o This meant 2 things
(1) if a child earned money they werent taxed on it (unless it was a lot of
money)
(2) large incentive to shift income to children
o 1986 Act changed this re: unearned income (interest, dividends, capital gains)
Eliminated exemption for dependents it went to parents
Std deduction was reduced to $500 max. (Today its $950)
Kiddie tax
Originally for children under 14. Then 18, then 23
1st $950 = no tax
2nd $950 = 10%
The rest = parents rate
What do you do w/the net unearned income?
Aggregate it for all children, compute parents tax liability w/o it, then
add it in, compute the extra tax, and then pass the tax back to the
children.
If the childrens income is less than 10x that amount you can simply
report it on the parents return.
Earned income
Still taxed at the childs rate
Regular std deduction capped t the greater of $950 and earned income.
What does this mean?
o Assume regular std deduction is $500.
o If you have $2,000 of unearned income and no earned income,
you std deduction was greater of $950 or earned income, so
$950.

55

o
o

If your earned income was $3k your std deduction would be

normal std deduction ($5k) but not greater than earner income,
so $3k.
What if you had $3,000 earned income and $1 of unearned
income?
Std deduction is $3k, AGI is $3,001, taxable income
is $1, have to file a return.
This was silly. Alternative is now earned income +
$300.

Treatment of Divorce

(1) Division of property

o Old method didnt work out very well. Couples didnt like having to pay a tax when they
were getting a divorce.
o Also it was a trap for the IRS.

(2) Alimony
o Income splitting model
Any income paid as alimony from one spouse to the other is includable by the
payee and deductible by the payer
If you have unequal earning spouses who used to get 167% of the bracket now
get 200% perfect income splitting in divorce you werent permitted in
marriage
o 71(b)
Alimony must be in cash
Deduction is an election

(3) Child Support

o Amounts designated as child support or amounts that look like child support. Ex: if
you call it alimony but you reduce it when each child gets out of school, then its child
support.
o Taxed to the payer rather than the payee.

Assignment of Income
Income from Services
Earned Income
o Earned income = taxable to the person who earned it.
o This is the general principle.
CASE Lucas v. Earl (US, 1930)
(489)

FACTS / PROC HISTORY: Married couple had a K that stated everything was joint property.
Tried to claim that half of Hs income was Ws income.
HOLDING: Court rejects this.

Income from Property

Property Income = taxable to the person who owns the property
o Horst if you have the asset, and just transfer the income, this wont be respected (not
true for bonds.)
o Blair If all you have is the income, you can transfer that and it will be respected.

56

CASE Helvering v. Horst (US, 1940)

(499)

FACTS / PROC HISTORY: TP ows a bond. Bond has coupons. TP rips off the coupons and
gives them to son. When they mature, son cashes them in. Who should be taxable?
HOLDING: Coupons remain taxable to Horst.
RULE: cant just transfer the income from an asset if you are still holding the underlying
asset.
COMMENTS: Horst is still good law, but not w/respect to bonds.

Ripe vs. Non-Ripe

o With respect to ripe, you are likely to be taxed on it even if you dispose of the corpus.
If you sell a bond w/accrued coupons, some amount of the sale price is deemed
to be accrued income taxable as ordinary income.
If I txf stock after the dividend date, this is viewed as ripe earnings taxable to
me, not the recipient.
What if I have appreciated property that I give to a charity? Not taxable.
What if I enter into a K to sell the property and give it to the charity subject to
that K? This more like the ripe fruit.
o Where you draw the line is unclear.
What if you separate the interest and the coupons and you give the corpus to
your daughter and the coupons to your son?
This will probably be respected.
Similar to a trust where you give a life interest to your wife and the
remainder interest to your son. Youve disposed of your control

CASE Blair v. Comm (US, 1937)

(497)

FACTS / PROC HISTORY: TP only has the right to the income. He does not own the
underlying asset. He gives a share of his income to his children.
HOLDING: The TP has given them all hes got, so the transfer is respected.

57

CAPITAL GAINS AND LOSSES

Generally

All gains and losses are either capital or ordinary

TPs generally prefer capital gains, because they are often taxed at lower rates (currently 15%); but
They prefer ordinary losses, which are deductible in full from ordinary income while capital losses generally
are deductible only...
o to the extent of capital gains, plus
o a limited amount of ordinary income (currently $3,000)

Policy of Preferential Treatment of Capital Gains

f.

Arguments in favor of preferential treatment

General Argument

Why a Problem

Explanation

Critics Response

Capital gains are not

income

Capital gains are nonrecurring

Progressive tax should be

imposed only on recurring
items, should exclude
extraordinary gains &
windfalls

Narrow view of income

rejected in Glenshaw Glass;
problem b/c then income tax
wouldnt reflect ability to pay

Capital gains simply reflect

changes in interest rates

Capital gain due to interest

rate fluctuations do not
make a person
economically better off

But person is better off

compared to a person who has
not enjoyed the same gain
more purchasing power

Bunching

TP Spends 30 years
building biz, earning very
low income, then sells at a
hefty profit. Looks like they
have a huge gain at that one
moment in time, but its
really notspread over the
life of the biz, TP should be
taxed at a lower rate

Lower tax rate splits the

difference; makes tax rate
closer to regular income
rate for lower-bracket TP

Most TPs have capital gains

year after year; could solve
problem for one-time seller
with an averaging mechanism

Inflation

Capital gains often do not

reflect actual changes in
wealth but are merely due
to inflation

Lower tax rate is a crude

solution for the fact that a
certain portion of all gains
is due to inflation

But the right solution is to

index basis. When you sell an
asset, your basis would not be
the raw historical dollar
amount. It would be the
historical dollar amount
adjusted by intervening

Graetz says bigger

problem for longerheld assets, but Reed
disagrees, b/c real
gains = higher % of
total gains for longer-

58

held assets

inflation.

Lock-in effect

Right to defer gain can

mean people hold onto
assets even when they
would rather sell. Ex: I
have a big gain in an asset.
I think long term that the
asset will underperform in
the market. In a no-tax
world, I would sell. In a
tax-world, I would defer
my gain.

Preferential rate reduces tax

barriers and shifts
incentives back to
economically-motivated
choices

Its unclear how big this loss

is, but a major source of the
problem is step-up basis at
death

g. Arguments against preferential treatment

A dollar of capital gain is the same as any other dollar of economic gain
The preferential treatment of capital gains is a great source of income tax complexity
Capital gains preference creates too much inequity and too little "bang for the buck"

Mechanics of Capital Gains

Section 1(h)
o Operates off a concept called net capital gain
o NCG is the thing that gets preferential rates.
o What does NCG mean? Look to 1222.
(11) - The term net capital gain means the excess of the net long-term capital gain for the
taxable year over the net short-term capital loss for such year.
(7) The term net long-term capital gain means the excess of long-term capital gains for the
taxable year over the long-term capital losses for such year.
(3) The term long-term capital gain means gain from the sale or exchange of a capital asset
held for more than 1 year, if and to the extent such gain is taken into account in computing
gross income.
o Key requirements - Gain from the sale or exchange of a capital asset held for more than one year.
o What about capital losses?
Sale or exchange of a capital asset, but there is no holding period requirement.
o Section 1(h)(11) treats dividends as NCGs.

Netting issue
Short term
Long term
o

Gain
Ordinary income
Preferential rate

Loss
Ordinary income w/deduction w/$3k limit.
Ordinary income w/deduction w/$3k limit.

What if I have things in more than one box?

First net across the boxes horizontally.
I could have both short and long term gain
Fine. Taxed at each at their own rate.
I could have both short and long term losses
Fine. Losses can be combined,

59

But would you rather the $3k come from the short or long term pile?
Long term pile. Because can only offset against the long term gain. Want to carry
forward short term loss to offset future short term gain, because short term gain
doesnt get the preferential rate.
But the code requires you to use the short term loss first anti TP provision.

Compare sale and exchange w/ Section 1001

o 1001 gain from the sale or other disposition of property
o Does not say exchange. This is the difference between when you can go into the capital treatment
vs. the whole set of gains.
o Sales or exchanges is a subset of sales or other dispositions
Ex: cancellation of a K is a disposition but not a sale or exchange

Holding Period
o Normally an easy concept how long did you hold the asset?
o Has to be more than 1 year. If you buy on January 1, cant sell it until January 2.
o Tacking
You get to count some prior holding period w/your holding period.
Example 1: Dad owns stock and has owned it for 10 years. Gives it to you (you take his
basis), you sell it 3 months later. Is this long or short term?
Long term.
1223 you get to take dads holding period and count it as part of your holding
period.
Example 2: You own stock in a corporation, it merges w/another corporation and you get
tax of the new corporation.
Your old basis carries forward as does your holding period.

Section 1(h)
o Core type of CG now taxed at 15% or 0%.
o Other types of CG that we tax at less preferential rates
Collectables are taxed at 28%
If you are trying to encourage people to make productive investments, you dont
make productive investments in collectables.
Unrecaptured 1250 gain
Generally gain on real property is not recaptured
Recapture rules in 1250 dont really operate. They are there but dont have much
effect.
Rate is 25%. Gain on real property that would have been recaptured if we have a
functional recapture rule, but wasnt recaptured.

Definition of a Capital Asset

I.R.C. 1221 Capital Asset Defined
(a) IN GENERAL.For purposes of this subtitle, the term capital asset means property held by
the taxpayer (whether or not connected with his trade or business), but does not include
(1) stock in trade of the taxpayer or other property of a kind which would properly be included in
the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the
taxpayer primarily for sale to customers in the ordinary course of his trade or business;

Hypo
o

Youre GM and you sell cars. Do you get CG on your cars? No. Property held by the TP primarily
for sale to customers in the ordinary course of his T/B.

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o
o
o
o

If you are a reseller (CVS) also wont count.

But what if you both rent out property and sometimes you sell it? Was it held primarily for sale or
primarily for rental business?
Real Estate Cases were you holding the real estate for investment or for sale? Inherent ambiguity
b/c if you are holding it for investment you will need to sell it eventually to get your return on your
investment.
Securities dealers in general. Are you a dealer? Are you a trader?

Other 1221 Exclusions

o 1221(a)(2): property used in T/B, entitled to depreciation under 167 or is real property
o 1221(a)(3): copyright, literary, musical, artistic composition, letter or memo held by TP who
created it, TP for whom created if letter or memo, or TP in whose hands basis is determined
o 1221(a)(4): accts or notes receivable from ordinary course of T/B
ex: car dealer, take back note, receivable, later have gain/loss on receivable. Not investing
in debt, that was part of sale of car
o 1221(a)(5): U.S. govt publication
o 1221(a)(6): any commodities derivative financial instrument
o 1221(a)(7): any hedging txn which is clearly identified as such on date on which acquired
o 1221(a)(8): supplies of type regularly used or consumed by TP in ordinary course of T/B

CASE Malat v. Riddell (US, 1966)

(552)

FACTS / PROC HISTORY: TP bought land to build apt to rent (would be capital per
1221(a)). Plans change, TP sells some parcels (ordinary income); later sells the rest and
claimed capital b/c primary purpose was to hold for investment; selling remainder of land
terminates joint venture so not in ordinary course of business. IRS argues that there was a dual
purpose either rent or sell, whichever is more profitable.
HOLDING: Court disagrees w/IRS. Need to show that the number one purpose was sale in
order to tax it as ordinary.
RULE: The word "primarily" in 1221(a)(1) means "of first importance" or
"principally," and not just "substantial."

Continental Can
o Argue their primary purpose is rental, even though they were forced into some sales.
o Ct where there is a change in the purpose, the primary issue is the purpose at the time of sale.
If you take this literally you could never get CGs.
o Also argue there are two businesses going on sales and rental.

International Shoe
o Shoe making equipment was only sold, not rented. Antitrust case they have to rent it out too
o Court focuses on the ordinary course question.
o Sales were part of the ordinary course and that was enough.
o This distinguishes it from liquidation cases.
If I have a rental business and when the property becomes obsolete and I sell it in
liquidation then I can get capital gains b/c not an ordinary course of business sale.
CASE Bramblett v. Comm (5th C, 1992)
(556)

FACTS / PROC HISTORY: TPs try to separate the appreciation and development phases. First
they buy land as a pship. Later they sell the land to a corporation w/the same ownership
structure for development. IRS wants to attribute all the activity to the Pship.

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HOLDING: Court asks 3 questions: (1) Is the pship in the business of selling land? (2) Is the
corp merely an agent of the pship? (3) Can the actions of the corp be imputed to the pship?
Overall court disagrees w/IRS, respects the distinction between the pship and the corp.

Bramblett Analysis
o (1) Is the original pship in the business of selling land? (1221(a)(1))
Three questions: Engaged in a t/b? Held for sale? Ordinary course in the t/b?
Factors used re: held for sale in
Nature and purpose of the acquisition
Extent and nature of the sales efforts
Number, extent, continuity etc. of sales (most important)
Extent of subdividing developing, advertising, do they have a business office
How much time they put into it
Court thinks its not a very tough standard
o (2) Even if not, is the corp merely acting as the agent of the pship?
Corporation did not act in the name of the pship
Corp keeps the profits
Agent didnt have authority to bind the principle
identical ownership didnt bother the court
o (3) Can the actions of the corp be imputed to the pship? Can we essentially ignore the corp?
court had no trouble respecting the separate existence of the corp.
found a typical business purpose shielding the partners from liability. Presumably
development includes more liability than sales.

Securities Cases
o Courts have developed three categories
Investors someone holding for long-term appreciation. Not in a t/b. Clearly not
described in 1221(a)(1).
Traders buying the asset not for long term investment but for price swings. As long as the
trading is frequent and substantial then they are engaged in a t/b. Takes them out of 163(d)
but its not enough to make their gains and losses ordinary, b/c of for sale to customers
language. This is the distinguishing point between a dealer and a trader. Not in 1221(a)(1).
Dealers sells to customers, unlike the trader who sells to the market. Dealer is just trying
to get a mark up between the purchase and sale price. Described in 1221(a)(1). Also not
subject to 163(d).

Mixed Motive Cases

o If I have securities in my portfolio that go up I was holding them for investment but I will sell them,
and then I have CG. If I have securities that go down I saw I was holding them for customers, my
losses are ordinary.
o Very difficult for IRS to later question the original motivation.
o Solution is that you make them identify upfront their purpose 1236(a)
o Can still challenge, claim misidentification.
o 1236(a) cant get CG unless identified on the close of the day or such earlier time, its clearly
identified in the dealers records as a security held for investment, AND not at any time held by such
dealer primarily for sale in the ordinary course of T/B.

Depreciable Property and Recapture

Depreciable Property: Sections 1221(a), 1231, 1245, 1250

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Hypo: Assume I use a truck in my business and I sell it. I purchased it for $100k. I depreciate $15k. My
basis is now $85k. What is the treatment if I sell that truck for $110k? for $90k? for $70k?

Step 1: Section 1221(a)

o Is it a capital asset? No. It is ordinary.
Step 2:
o
o
o

Section 1231
if 1231 gains > 1231 loss then they net out and you have a long-term net gain.
If this was our only sale, it would be a capital gain.
1231 applies primarily to sale or exchange of t/b essentially means 1221 property held for more
than one year but doesnt include any other inventory property (1221(a)(1) and () and timber and
livestock)
o Also applied to a compulsory or involuntary conversion of such property and any capital asset held
for more than one year for a t/b or txn for profit
o 1231 two-stage netting process
gain from sale of truck = capital; loss from theft of asset = ordinary
What if they happen in the same year? netted together. But what does that mean?
Assume Ive already sold the truck. Then the other asset gets stolen. In effect, my CG is
converted to an ordinary gain b/c its offset in the netting process.
Congress has set up a two stage process
(1) look at your net from involuntary conversions. If a net loss its ordinary and
taken out of the computation, not netted in the next phase. If its a gain, you do
include it in the next stage.
(2) next stage
o I have two assets (one gain one loss) I really want CG on one and OL on the other. Can I do that by
doing it in two separate years? Ability to do so is limited by 1231(c). If I take a loss in the first year
and a gain the next year, there is a recapture process and the gain is ordinary. But if you do it in
reverse you are ok.
$110 (gain)
90 (gain)
70 (loss)

1221(a)(2)
Ordinary
Ordinary
Ordinary

1231(a) (1) & (2)

Capital
Capital
Ordinary

Step 3: Section 1245 (personal property)

o Looks like gains are capital and losses are ordinary. But thats not right. First $15k of gain is just
prior depreciation. Seems wrong that you can take an excessive depreciation deduction.
o Section 1245 says no to the extent of prior depreciation your gain will be ordinary.

$110 (gain)
90 (gain)
70 (loss)

1221(a)
(2)
Ordinary
Ordinary
Ordinary

1231(a) (1) &

(2)
Capital
Capital
Ordinary

1245
$15k ordinary; $10k capital
Gain ordinary
Loss ordinary

Step 4: Section 1250 (real property)

o What if instead this was a building instead of a truck?
Answer will be different. 1245 applies to personal and not real property.
Building is subject to 1250.
Only deal w/additional depreciation to the extent that it exceeds straight line.
I buy a building, depreciate it, then sell it. How much additional depreciation will I have?
None. Because you have to do straight line depreciation.

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The excess of depreciation over straight line = 0.

$110 (gain)

1221(a)
(2)
Ordinary

1231(a)(1) &
(2)
Capital

90 (gain)
70 (loss)

Ordinary
Ordinary

Capital
Ordinary

1245

1250

$15k ordinary; $10k

capital
Gain ordinary
Loss ordinary

15k cap [25%]; 10k cap

[15%]
5k cap; [25%]
15k ord loss [35%]

For the $110, why is the 15k an 10k separate?

The 5k (for 90) and the 10k for (110) is unrecaptured 1250 gain would be relevant except
1250 doesnt do anything. Half recaptured.

Derivatives, Hedging and Supplies

What is Hedging?

Pre-Corn Products Hypo

o I am a farmer, will have 10k bushels of corn to sell in June. Its April. I can estimate my costs are
about $2/bushel. Whats my cost going to be?
o Look at futures market. Right now June corn sells for $2.35/bushel. Looks like I will get $0.35 per
bushel profit.
o But I want to lock in that profit corn is volatile.
o I can guarantee my profits by entering into a K to sell corn. I want an off-standing short K.
o I enter into a K to sell at $2.35. I will for sure make $0.35 / bushel.
o If In June, corn is $1.80 I can simply sell the corn under the K. $0.35 gain ordinary (selling to
customers / inventory)
o Or I can sell the corn and cash in on the K.
Loss will be $0.20. Loss will be ordinary.
And I sell the K. K is worth $0.55. Anyone can take the K, buy corn for $1.80 and sell it
for $2.35. Net is $0.35. What is the character of the sale on that K. Capital. Im not a
dealer in Ks, Im a dealer in corn.
So I will chose to sell the K. I like the offsetting loss.
o What if corn is $3.00.
I can sell it under the K for $2.35 and will have a $0.35 gain, ordinary.
Or I can sell the corn on the market with a $1.00 ordinary gain. The K is bad, so I have a
$0.65 loss, capital. I will chose the $0.35 ordinary gain. I will just sell under the K.
Gov issued a GCM ruling about this. True hedges are like insurance. Legit hedges, costs thereof is ordinary
and necessary. Proceeds from are reflected in [ordinary] net income. So they say its all ordinary.

Corn Products & Arkansas Best

CASE Corn Products v. Comm (US, 1955)
(572)

FACTS / PROC HISTORY: CP is buying corn for its inventory. CP has Ks to buy the corn.
CP closes out those Ks and wants capital treatment. CP tries to argue they werent hedging.
HOLDING: if the hedge was directly related/integral to the business/manufacturing activity of
the business, then the purpose of securing the hedge was business related, hence it is treated as
ordinary
RULE: People read Corn Products to say that if it is an integral part of your business
then it is ordinary.

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CASE Arkansas Best v. Comm (US, 1988)

(575)

FACTS / PROC HISTORY: TP invests in a bank that is initially doing well. It starts doing
badly, TP invests more money, but eventually sells the stock at a loss. Lower court says there
was a business motivation for the investment so it is ordinary.
HOLDING: There is no integral to your business test in the statute. Corn Products has been
misread. In Corn Products the key was that it was integral to the inventory purchasing system.
RULE: only hedging transactions that are an integral part of the business inventorypurchase system fall under the exception of 1221

Post-Arkansas Best

Was the hedging doctrine narrowed?

o IRS took the position that it was. Only thing allowed was an inventory hedge, like Corn Products.
o But the farmer example, where he is selling his product, wouldnt be ordinary, b/c its not a substitute
for his product.
o So people who had identified ahead of time, but then were screwed b/c of the misreading of corn
products, were they screwed? IRS says yes. Litigated in Fannie Mae.
Fannie Mae IRS loses the case. There is still a hedging doctrine.
Post-Fannie Mae
o Then after this Treasury issues a regulation saying that hedging of ordinary items are ordinary.
1.1221-2.
o Also wrote an accounting regulation, which for the first time, changed the timing rules re: hedges
If you were going to borrow in six months, and entered into a K, and you had a loss on that
hedge, then you could no longer take the hedge right away. Realization is irrelevant, had to
take the loss and spread it into the debt.
This is a significant change. Congress springs to life.
o Congress enacted 1221(a)(7) current statutory hedging rule. Any hedging txn clearly identified
as such is ordinary.
I.R.C. 1221 Capital Asset Defined
(a) IN GENERAL.For purposes of this subtitle, the term capital asset means property held by
the taxpayer (whether or not connected with his trade or business), but does not include
(7) any hedging transaction which is clearly identified as such before the close of the day on which
it was acquired, originated, or entered into (or such other time as the Secretary may by regulations
prescribe);
o
o
o

1221(b) defines hedging txns.

Has to be a hedge of an ordinary item.
Another piece a problem for supplies that are not themselves inventory. For example, jet fuel for
an airline.
Post A-B it is no longer part of your inventory. So then it becomes capital.

Straddle Contract

What if instead, you enter into a K to buy corn and an essentially identical K to sell corn.
o What risk have you taken on? Zero.
o If corn prices go up, your K to buy at a set price is going to be valuable. Your sell at that lower set
price is going to be a liability. The two should offset.
o There is also essentially no credit risk b/c of the design of exchanges.
Why did you enter into this transaction?
o You do this in October. Come December, what has happened to the Ks?

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Assume its gold. Gold is now at $1500, at the time of K it was at $1300. Youve made $200 on the
buy and lost $200 on the sell side.
o You close out the sell side, you have a $200 loss.
o You immediately enter into another K for gold to offset future risks.
o Youve essentially placed two bets. You will win one and lose one. But you will lose the bet this
year and win next year. You can defer the income until next year.
o At very low cost you can defer the income forever. (Reed has oversimplified this they cant be
literal mirror images or the exchange will close them out. So buy April gold and sell May gold.)
Congresss response
o Enacted 1092 and 1256. But they dont apply to legitimate hedgers.
o How to solve this problem?
Limit the loss to the first year. (1092)
Or accelerate the gain. (1256) mark to market
o As a political compromise we also gave 40/60 treatment 60% of gain is long-term, 40% is shortterm. Exception to the usual holding period requirements.
o

Non-Recognition Transactions
Like-Kind Exchanges

Requirements
o 1031(a)(1) investment piece of property or part of a t/b
Personal asset, like a home, doesnt count.
o (a)(2) exceptions: stocks and bonds, property held for sale, etc.
1031 is a very generous provision. Youve held the asset for many years, you have had gain, weve let you
defer the gain, youve finally disposed of the asset, and we are letting you defer it more.
o Why do we allow this?
Liquidity reasons
Valuation reasons
But these would apply to any exchange. Maybe it just reflects the power of the real estate
lobby.
See the handout for notes on Like Kind exchanges.

Calculating Basis:

I.R.C. 1031(d) Like Kind Basis Calculation

(d) BASIS.If property was acquired on an exchange described in this section, section 1035(a),
section 1036(a), or section 1037(a), then the basis shall be:
the same as that of the property exchanged,
decreased in the amount of any money received by the taxpayer
and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange.
If the property so acquired consisted in part of the type of property permitted by this section,
section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain
or loss, and in part of other property, the basis provided in this subsection shall be allocated
between the properties (other than money) received, and for the purpose of the allocation there shall
be assigned to such other property an amount equivalent to its fair market value at the date of the
exchange.
For purposes of this section, section 1035(a), and section 1036(a), where as part of the
consideration to the taxpayer another party to the exchange assumed (as determined under section

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357(d)) a liability of the taxpayer, such assumption shall be considered as money received by the
taxpayer on the exchange.

67