TAX OUTLINE I. A. Introduction 1. Reasons to Tax Income a. Fair to tax according to ability to pay. b.

Income is a good measure of the ability to pay. 2. Goals of a Good Income Tax a. Fairness i. Horizontal: Tax people in the same financial system the same. ii. Vertical: As income goes up, so does the ability to pay. b. Practicality (Administrative Feasibility) c. Sound Economic Effects 3. Formula for Computing Tax Liability Gross Income Adjustments = AGI AGI- (Personal Deductions + Personal Exemptions) = Taxable Income Taxable Income x Tax Rate = Tax 4. Definitions of Income a. 61: Gross income is all income from whatever source derived, including but not limited to a list of 15 items. b. Eisner v. Macomber: Gain derived from capital, from labor, or from both combined. c. Glenshaw Glass: Gain from whatever source derived; Congress did not apply limitations to what could be taxed. d. Haig-Simmons: Sum of the fair market value of rights exercised in consumption and the change in the value of stored property rights over a specified time period. B. Non-Cash Benefits 1. General Rule Non-cash benefits ARE income. Income is not avoided because the tax payer is paid in a form other than cash. 61 declares that gross income is all income from whatever source derived. SOME CHARACTERISTICS OF INCOME

Reg. ' 1.61-1(a): AGross income includes income realized in any form, whether in money, property, or services.@ Reg. ' 1.61-2(d)(1): A[I]f services are paid for in property, the FMV of the property taken in payment must be included in income as compensation.@ Old Colony Trust Co. v. Commissioner: Court held that an employers payment of federal income taxes on behalf of its employee constituted income to the employee. The Court found it immaterial that the taxes were paid directly over to the federal government the discharge by a third person of an obligation to him is equivalent to receipt by the person taxed. 2. Meals & Lodging a. 119(a): The value of meals and lodging furnished to an employee, employees spouse, or an employees dependents is excluded from gross income if such meals and lodging are provided for the convenience of the employer, but only if: i. the meals are furnished on the premises of the employer, or ii. the employee is required to accept lodging on the business premises of his employer as a condition of employment. b. Bengalia v. Commissioner Facts: Bengalia was the manager of a hotel and received a free room on the premises and free room service as part of his employment contract. The IRS sought to tax this as income. Holding: The Court found that as manager of the hotel, petitioner was required to be present at all times, and therefore, his living at the residence was a necessary part of the job. Petitioner said that he would not work at the hotel and the hotel said they would not hire him unless he lived on the premises. Therefore, the Court found that petitioner was not required to include the value of the housing and the meals as part of his income because the advantage to him was incidental to carrying out his responsibilities. Aftermath: Congress passed 119, affirming the holding in Bengalia and exempting meals and lodging furnished for the convenience of the employer (i.e. forced on employee). 5 Alternative Ways to Tax Bengalia: (1) Retail FMV (IRS position), (2) Subjective Value to the Employee (impractical), (3) Cost of the alternatives to the employee (Dissent), (4) Cost to the Employer (Unknown), and (5) Forced Choice (Courts holding).

3. 132: Fringe Benefits a. 132 (a): Gross income does not include any of the following: (i) noadditional cost services (ii) qualified employee discounts (iii) working condition fringe benefits (iv) de minimis benefits (v) qualified transportation fringe benefits (vi) qualified moving expense reimbursements (vii) qualified retirement planning services. b. 132(b): No-Additional Cost Services. Gross income does not include services provided to the employee if such services are (1) offered for sale to customers in the ordinary line of business of the employer in which the employee is performing the services and (2) the employer incurs no substantial additional cost in providing the service. Example: airline employees flying standby for free. c. 132(c): Qualified Employee Discount. A qualified employee discount is any discount to the extent the discount does not exceed: (1) for property, the gross profit percentage or (2) for services, 20% of the price at which the services are being offered to customers. Example: Schwab offers its services to employees at cost (20%) no income to employee. Same facts, except that cost is 50% - no tax on first 20%, but tax on 30% in excess. d. 132(d): Working Condition Fringe Benefit. Any property or services provided to the employee to the extent that if the employee paid for such services, the employee could deduct such payment under 162 and 167 are not included in income. Example: Company paying you to see a psychologist. i. If you could deduct the expense personally, and the good/service is offered by an employer then the value isnt included in income. e. 132(e): De Minimis Benefits. Any property or service, the value of which, is so small as to make accounting for it administratively impractical (e.g. coffee at the office) is not included in income. i. Eating facility is dmf: (i) On/near ers business premises, (ii) The operation at least breaks even

f. 132(f): Qualified Transportation Fringe. An employee may exclude up to $115/month for the cost of mass transit and up to $220/month in parking so long as this is in association with employment.

i.

This kind of tax policy gives incentives to drive because it is the only scenario where the employee receives more value (where the parking is not taxed)

g.

132(g): Qualified Moving Expenses excluded from income.

h. 132 (h): Certain Individuals Treated as Employees for No-Additional Cost Services. The following are treated as employees for no-additional cost services and are not required to include the benefit of these services in income: retired employees, spouses of employees, dependents children of employees, and parents of employees (but only for air travel). i. 132 (i): Reciprocal Agreements. For purposes of no-additional cost services, if employer A agrees to provide services to am employee of employer B and vice versa, then the employee of company B may exclude the value of from income if: (1) the service is provided pursuant to a written agreement between the employers and (2) neither employer incurs any substantial additional costs in providing the service (3) the employers are both in the same line of business. Example: Delta employees flying standby on United is O.K. Example 2: Agreement between Delta and Hilton not O.K. because not same line of business. j. 132 (j)(1): No-additional cost benefits and qualified employee discounts only apply to highly compensated employees if the fringe benefit is available on substantially the same terms to each member of a group of employees. Employers cannot set up groups that discriminate in favor of highly compensated employees. i. 132(j)(1) only applies to 132 (a) and (b). Example: Cant just give pilots benefits and not grounds crew. Doesnt trump the de minimis fringe benefit 132 (j)(4): Gross income does not include the value of an athletic gym so long as the gym is on the premises of the employer, is operated by the employer, and its main use is for the employees, their spouses, and their dependent children. 162(a): Insurance deductible by employer 106(a): Benefits excluded from employees incomenon-covered employee does not fall within this section, but self-employed does 213: individuals can deduct medical expenses (including insurance) only to extent they exceed 7.5% AGI

4. Valuation of Benefits 132 and 119: All or nothing provisions a. Turner v. Commissioner

Facts: TP won two tickets for a cruise between NYC and Buenos Aires. The tickets were non-transferable and had to be used within a year that they were issued. TP reported income in the amount of $520, which represented the value of the tickets to him, but the Commissioner determined that the amount that TP should have claimed the retail value of the tickets in his tax return which was $2,220. Holding: The Court split the difference, and determined that the value of the tickets was $1,400. The Court compromised, reasoning that the value to the petitioners was not retail value, but it was worth more than the TP said it was worth. C. Windfalls & Gifts 1. Punitive Damages a. Commissioner v. Glenshaw Glass Co.

Facts: Glenshaw won punitive damages but did not include them as income on their tax return. The IRS argued that punitive damages are income under 22 of the former tax code, which says that gross income includes gains, profits, and income from whatever source derived. Holding: Income because the TP has an undeniable accession to wealth, that is clearly realized, and which he has complete dominion. Result Today: 61(a) is a catch-all that covers all realized accessions of wealth, regardless of the source, so long as they are not specifically excluded in the statute. Congress did not exclude punitive damages from income, so they are considered income. Reason for Decision: At the time 61 was not the law; 22 was the law which says that GAINS from whatever source derived are income. Therefore, punitive damages qualify as income. Policy Reasons: TP argues that this is a windfall and not a gain, but it would be strange to tax income but not windfalls. A person who finds 100k on the street is just as well off as someone who earns 100k in income. Therefore, both are taxed. Court also says that Congress intended to tax all gains except those specifically excluded, and since Congress did not exclude punitive

damages, the decision is correct. (Cesarini: income if you buy a piano for $15 and find $4500 inside) 2. Gifts a. 102: Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. b. Example Donna earns 100k/year, and her son earns nothing. Donna gives her son 30k/year. Three ways to treat the transfer: (i.) income to Edward, deduction for Donna (Es income = 30k, Ds = 70k), (ii) income to Edward, no deduction for Donna (Es income = 30k, Ds = 100k), (iii) no income to Edward, no deduction for Donna (Es income = 0, Ds = 100k). c. Commissioner v. Duberstein; Stanton v. United States Facts: TP transacted business with Bermans company (Mohawk), and would occasionally inform Berman of some potential customers who might be interested in Mohawks. Berman profited from this information, and in appreciation, he gave TP a car. Mohawk deducted this as a business expense, and TP did not include the value of the car in his income for that year. IRS alleged a deficiency in TPs income statement. In Stanton, the TP had worked for a church for 10 years. He left the church to go into business for himself. Upon his departure, the church gave him a gift of 22k in exchange for TP agreeing to terminate any pension payments he might otherwise be entitled to. Test: A gift proceeds from a detached and disinterested generosity given out of affection, respect, admiration, charity, or like impulses. Outcome: Income for Duberstein (finding by the tax court), gift for Stanton (finding by the district court). Result is an amorphous standard with TP arguing that the transfer was a gift and not income, and donor arguing that it was not a gift, and therefore, deductible. Congress overruled these cases by statute. The tax treatment of a transfer depends on the donors intent. The government wanted an objective standard whereby transfers given in the family context would be treated as gifts, and transfers in the commercial context would be treated as income. Instead we have a subjective standard that is fact-based (totality of the circumstances based on the experiences of the tribunal---extremely subjective).

Whipsaw- the IRS loses no matter what the case. Result Today (stopping the whipsaw): 274(b): Congress passed 274(b), which says that a donor may deduct the value of a business gift up to $25, and the donee is not required to include the value of the gift in income. 274(b) applies to gifts to individuals, whereas 102(c) applies to gifts to employer/employee context. OVERRULES THE RESULT IN DUBERSTEIN. 102(c): Employers are allowed to deduct business gifts to employees, and employees are required to include the value of the gift in income. (except if it is fringe benefit, or employee achievement award) OVERRULES STANTON. d. United States v. Harris Facts: Over the course of many years, TPs received over 500k each from Kritzik. Both were convicted under a statute that makes it illegal for a person to willfully fail to file a tax return when he is required to do so. TPs argued that: (1) the transfers were gifts and therefore not income and (2) that the government did not prove that they willfully failed to file tax returns. Two Ways to Treat the Transfers for Tax Purposes i. Gifts: Under this treatment, the transfers were gifts to the sisters. Since 274(b) allows individuals to exclude the value of the gift from income, the sisters would not be required to include these transfers in income. The transfers would instead be subject to gift tax to be paid by Kritzik. Income: Under the second approach, the transfers are treated as income to the sisters. This approach would require the TPs to include the value of these transfers in their income and would exempt Kritzik from paying the gift tax.

ii.

Holding: 7th Circuit reversed the convictions on the ground that the government did not prove both that the transfers were income, and that the TPs willfully failed to report the transfers as income. In order to prove that the transfers were income, the government had to show that Kritzik did not act out of a detached and disinterested generosity, but rather paid the money out of a sense of moral or legal duty or paid the money for services rendered or anticipation of services rendered. Since the tax treatment depends on the donors intent which is not ascertainable since he is dead, it is not clear whether or not he gave the money as a gift or if was for payment of services.

In addition, the law is not clear on whether or not these transfers were income. As a result the TPs were not given notice, and therefore could not have acted willfully. IRS argued that Harris said that she earned the money by lying on her back, but the Court said that tax treatment depends on the donors state of mind, not the donees. Therefore, just because she treated it as a job does not make it income. Olk v. United States: Tips for a service provider are treated as income and not gifts. 3. Prizes and Awards a. 74(a): Except as provided in this section or in 117, gross income includes amounts received as prizes and awards. b. Wills Case: TP won the Hickok belt, which is given every year to an athlete in recognition of athletic excellence. TP argues that athletic excellence should also come within the 74(b) exception. 74(b): Gross income does not include amounts received as prizes & awards made in recognition of religious, civic, charitable, scientific, educational, artistic, or literary achievement, but only if the recipient received the award without any action on his part, is not required to render substantial future services as a condition to receiving the award, AND transfers the prize to a governmental organization. Result today: even if it falls within the exception, 74b3 makes you give the award to charity...if you do both, then there is no reportable income. Holding: Income to the TP. At the time of this case, the third condition (requirement to transfer to governmental body) was not included in the tax law. Court said that Congress did not include athletic prizes for a reason and since it was not in 74(b), the prize should be included in income. 4. Scholarships a. 117(a): Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization. b. 117(b): Qualified scholarships apply to tuition, fees, supplies, and books. NOTE: This does not include room and board!!!

c. 117(c): Subsections (a) and (d) (tuition reduction) shall not apply to that portion of any amount received which represents payments for teaching, research, or other services by the student required as a condition for the scholarship. (Services= taxable income) If a student promises to work in the public interest area after graduation, and his scholarship is contingent on this...? (the services are different than the 117c elements...the school is not going to benefit from the exchange) Athletic scholarships? (can the scholarship be revoked if the services are not rendered?...NCAA says that scholarships cannot be revoked if people decide not to play) Editor-in-chief of the law review scholarship...income? 5. Transfers of Unrealized Gains and Losses a. Taft v. Bowers

Facts: In 1916, A bought stock for $1,000. In 1923, A gifted the stock to B. At the time of the transfer, the stock had a FMV of $2,000. Later that year, B sold the stock for $5,000. IRS claimed that B should have to pay tax on $4,000, arguing that B took As basis in the stock. B argued that his basis in the stock was the value of the stock at the time of the transfer and that he should not be required to pay tax on the appreciation of the asset during As ownership. Four Alternative Tax Treatments i. 1014(a) Basis for Transfers at Death (B's argument): The basis of property in the hands of a person acquiring the property from a decedent shall be the FMV of the property at the date of the decedents death. B argues that the transfer is akin to a transfer at death, and that he should be able to take the basis at the time of the transfer. Under this treatment, A would pay no tax, and B would only be taxed on $3,000. ii. Recognition by A at the Time of Transfer: The transfer of the property from A to B is a recognition event to which A should pay taxes. Under this treatment, A would be taxed on $1,000, and B would be taxed on $3,000. However, the problem with this view is that A does not have the cash to pay the tax. iii. 1015(a) Carry Over Basis (Current law): As basis in the property carries over to B at the time of the transfer. Thus, A pays no tax, and B pays tax on $4,000. In a property transfer, if there is gain on the sale of property, then the donee takes the donors basis as his basis. However, if the property is sold at a

loss, then the donees basis is the lesser of either the donors basis or the FMV at the time of the gift. iv. Reverse Surrogate Taxation: A is taxed on all $4,000, and B is not required to pay any tax. Holding: Third approach is used, and since there was a gain, B takes As basis, and so the gain on the sale is $4,000. 6. Calculation of Gain 102a- Gifts are not income. 61 a 3: income does include gains from dealings in property. When the donor's basis is greater than the realization amount, then it is a loss. If you then calculate and somehow it turns out to be a gain by the calculation, then it is a wash. 1001: Gain from the sale of property is the excess of the amount realized over the adjusted basis, and the loss shall be the excess of the basis over the amount realized. (AmRe- Basis= Gain) 1012: Basis equals the cost of acquiring the property. 1014(a): (Bequest) The basis in the hands of a person acquiring property from a decedent is the FMV at the date of death. Examples: (1) Donors basis: $1,000; FMV at death: $2,000; Sale Price: $5,000. Gain is $3,000. (2) Donors basis: $1,000; FMV at death: $2,000; Sale price: $1,500; Loss: $500 (3) Donors basis: $1,000; FMV at death: $2,000; Sale: $500; Loss: 1,500. ALWAYS TAKE BASIS AT FMV AT TIME OF DEATH NO MATTER WHAT. 1015(a): In property transfers that result in gain, the donees basis is the same as the donors basis. However, in cases of loss, the donees basis is the LESSER of either the donors basis or the FMV at the time of the gift. 1016: Adjustments to basis. Examples: (1) Donor has a basis of $1,000. FMV at time of gift is $2,000. Sale is $5,000. Gain is $4,000. (2) Donor has a basis of $1,000. FMV is $2,000. Sale is $1,500. Gain of $500. (3) Donor has a basis of $1,000. FMV is $2,000. Sale is $500. Loss is $500. (4) Donors basis is $1,000. FMV is $500. Sale is $250. Loss is $250. (5) Donors basis is $1,000. FMV is $500. Sale is $750. Neither gain nor loss. Off-setting transactions because sold for

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more than fmv but not enough to recover your basis. Congress didn't envision this result. 7. Gifts of Divided Interests Example: Grandparent dies with $100,000, used to buy a 15 year CD at 5%. The $5,000 a year is to be used by the child as needed for the benefit of the grandchild with the remainder to go to the grandchild at the end of 15 years. Three Possible Ways to Tax the Interest i. Childs Argument: 102(a) provides that property acquired by gift, bequest, devise, or inheritance is not to be taxed. Therefore, under this section, the child should not be taxed on the interest generated from the CD. This argument is problematic because Congress meant to exclude the value of the property from taxation, not income generated from the property. Under this result, income fro m property as well as the property itself would be excluded. ii. IRSs Argument: 102(b) says that gross income shall not exclude income from any property under 102(a) or the amount of income where the income is generated by gift, bequest, devise, or inheritance. Problem with this is that child has 0 basis and gets taxed on all 75k. Grandchild has 100k in basis so pays no tax when he receives the 100k after fifteen years. iii. Pro-Rata: Allocate the basis between the child and the grandchild. The present value of 100k 15 years from now is 48k, and the PV of $5k/year for 15 years is $52k, so give the grandchild a basis of 48k and the child a basis of 52k. Each recovers 1/15 of their basis each year. Thus, income for the child is 75k-52k = 23k. 23k/15 =1,534, and income for the grandchild is 100k-48k=52k. 52k/15= 3,466. The problem with this is that the grandchild has to report $3,466/yr (1/15th) in income even though he is not earning income. The amount of taxes that he pays (on $3,466/yr for 15 years) when added to his initial basis will be $100k, so when he receives the $100k, he will not owe any taxes. This is an example of OID, where the PV of the gift is $48k, but the total amount of money, when received is $100k. Therefore, this $52k should be taxed as income.

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Taft v. Bowers: we will tax the person who did not earn the income. D. Recovery of Capital 1. Three Examples a. Buy one share of stock for 100 and later sell for 200. 200 realized -100 basis =100 gain b. Buy 10 shares of stock for 100; later sell 5 shares for 100. Basis: $100/10=$10/share 100 realized -50 basis =50 gain c. Buy 10 acres of land for $100. 5 acres in Indian Hill 5 acres in Madisonville Indian Hill land is worth 3 times as much. What happens when you sell all 5 acres in Indian Hill for $100? Is it the same as b? No. Indian Hill is worth 3 times as much, so allocate the basis accordingly. 100 realized -75 basis =25 gain 2. Four Possible Approaches to Recovery of Capital (when can the tax cover implement the basis) Example: TP pays 1 million for a gold mine, which produces 300k per year. The mines expected life is 10 years. How do we allocate the basis? a. Basis First: Years 1-3: 300k payment -300k basis = 0 income 300k payment -100k basis =200k income 300k payment -0 basis =300k income

Year 4:

Years 5-10:

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b. Basis Last: Years 1-10:

300k payment -0 basis =300k income 0 payment -1 mil basis = (1 million) 300k payment -100k basis =200k income

Mine at Shutdown: c. Pro Rata: Years 1-10:

d. True Economics- assuming it is $ and not a mine (@27.3% interest) basically we are going to take the basis and spread it out over the ten years, using a little at first, and a lot at the end- compromise. Favors the IRS more than the pro rata approach. The example treats a bank account balance like the 'box of basis.' Year 1: Opening Balance: 1 million Interest: + 273k Subtotal: =1.273 mil Payment -300k New Balance: =973k . Year 10: Opening Balance: Interest: Subtotal: Payment: New Balance: Inaja Land Co. Facts: TP paid 61k for certain land and riparian rights. In 1934 L.A. began to construct a tunnel nearby which polluted TPs land, and TP sued. TP and the city reached a settlement whereby the city was to pay him 49k for the resulting diminution of the value of his land, and TP agreed to discharge any claim he may have against the city regarding the decreased value of his property. TP did not include the 49k in his income for that year. A few years later he sold the land for 25k. IRS: Advocated the Court to adopt a basis last approach. This approach would have required TP to include the 49k he received in year one in his tax return and would have allowed him to deduct 36k at the time of sale (25k realized-61k in basis = (36k). 235k +65k =300k -300k =0

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TP & Court: TP advocated and the Court adopted a basis first approach. Under this approach, TP can use all of his basis up to the amount realized in the first year and use whatever is left over in the second year. Under this approach, TP would use 49k/61k basis in the first year, so income would be 0, and would use the remaining 12k in the second year, so income would be 13k in the second year. Problem: Basis last is too harsh to TP because it does not allow him to allocate any basis towards a partial sale. Basis first is too generous because he should have to pay some tax on partial sale. 3. Life Insurance a. 61(a)(10): Gross income includes income from life insurance. b. 101(a): Except otherwise provided, gross income does not include amounts received under a life insurance policy if such amounts are paid by reason of the death of the insured. Term life insurance only gives money if you die before retirement (insurance element). Savings element. c. Example: Life Span A B C 14.5yrs 0 yrs 25 yrs Premium Paid 25k 25k 25k Invt Death Growth Ben. 100k 25k 271k 100k 100k 100k Invt Mortality Gn/Loss Gn/Loss 75k 0 246k 0 75k (171k)

TP: B is best deal Ins Co.: C is best deal Wash: A How does TP protect himself from living too long? d. Mortality Effect & Savings Effect Mortality effect can best be thought of from the gain of dying early. For example, if you pay 1k for life insurance coverage that lasts one year and pays out 50k, if you die in that year, the mortality gain is 49k. If you do not die, there is a mortality loss of 1k. Thus, if the person dies, 101(a) excludes the 50k payment from taxation. However, if the person does not die, there is no deduction for the 1k paid out.

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The savings effect can best be illustrated in the following example: if A makes a one time payment of 25k in return for a payment of 100k at death whenever that occurs, they are able to do this because they can invest the 25k (tax free) and will eventually make more than 100k off this initial investment. The growth of the money from 25k to more than 100k is the savings element. 4. Annuities & Pensions a. Example 1 TP has a life expectancy of 2 years and buys an annuity for $200. The interest rate is 10%, and the annual payments are $115.24/year. TP lives for exactly 2 years. How do we treat the recovery of cost? i. Basis First: Year 1: 0 Income Year 2: Basis = 200-115=85 Income = 115-85=30 ii. Basis Last: Years 1&2: Income=115 At Death: (200) iii. Pro Rata: Formula: Basis/Term. In this case: 200/2=100, so income of 15/year. 72(b): Provides that recovery of basis is excluded from income on a pro rata basis. (e.g. 200/230=86.6%. 86.6% of 115 is excluded which is 100). iv. True Economics: Year 1: Opening Balance: 200 Interest: + 20 Subtotal: =220 Payment: -115 New Balance: =105 Opening Balance: 105 Interest: +10.5 Subtotal: =115.5 Withdrawal: -115.5 New Balance: =0

Year 2:

Example 2: TP buys an annuity for 100k and has a life expectancy of 20 years. The interest rate is 6.395% and annual payments of 9k. TP lives exactly 20 years. How should basis be allocated? 15

i.

Basis First: Years 1-11: Income=0 (use all of basis). Year 12: Income=8k (use remaining 1k) Years 13-20: Income=9k

ii. Basis Last: Years 1-20: Income=9k At Death: (100k) iii. Pro Rata: 100k basis/20years=5k basis/year Years 1-20: Income= 9k-5k=4k What happens if TP dies in year one? A still has 95k of basis left. Old rule said no deduction. Under 72(b)(3) TP is entitled to deduct remaining 95k in final tax return. What happens if TP dies in year 30? Old rule said you didnt have to claim income from years 21-30. New rule says income in amount of 9k from years 21-30. iv. True Economics: Year 1: Opening Balance: 100k Interest: 6,395 Subtotal: 106,395 Payment: 9k New Balance: 97.4k Year 2:Opening Balance: 97,395 interest: 6228 Subtotal 103,623 Payment 9k new Balance: 94.623 Etc. 5. Gains and Losses from Gambling

165(d): Losses from gambling shall only be allowed to the extent of the gains from such transactions. Therefore, if you win $500 at blackjack but lose $300 at poker, you are allowed to deduct the $300 lost at poker, so your income is only $200. But if you win $300 at blackjack and lose $500 at poker, you can only deduct $300/$500, for a loss of 0. The result is over taxation of gambling. This is done because Congress does not want to incentivize gambling. 6. Recovery of Losses

Clark v. Commissioner

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Facts: Tax lawyer gave bad petitioner bad tax advice which cost petitioner an extra 20k of taxes for 1932. The tax lawyer admitted his mistake and paid him the 20k in 1934. The Commissioner argued that this 20k was income to the petitioner in 1934. Holding: Court said that petitioner did not receive income in 1934; this was payment for recoupment for a loss, and as such, was not income. This payment did not meet the definition of income at the time which was that income was any gain derived from capital, from labor, or both combined. The Court said that since the petitioner could not deduct this loss in 1932, he should not be taxed on the recoupment of his loss in 1934. E. Annual Accounting 1. Two Methods of Accounting a. Cash Method: A TP using the cash method is required to report income as soon as the cash is received and is allowed to take a deduction only after cash has been paid out. The cash method favors practicality over fairness. b. Accrual Method: A TP using the accrual method is required to report income as soon as income is earned and is allowed to take a deduction only after the obligation to pay has been incurred. The accrual method favors fairness over practicality. Theme: Courts further practicality by enforcing annual accounting. This leads to unfairness in the real world where complex transactions are spread out over more than one year. In order to remedy some of this unfairness, Congress has enacted specific forms of statutory relief. 2. Hindsight Burnett v. Sanford & Brooks a. Facts: Respondent entered into a contract that required it to perform services spanning a number of years. For the years 1913-16, respondents expenses exceeded the payments it received under the contract by 176k. They declared losses totaling 176k for the years 191316. In 1916 work on the contract was abandoned, and respondent brought suit seeking to recover the 176k on a breach of contract suit. In 1920 judgment was given for respondent in the amount of 176k. The TP argued for transactional accounting and claimed that the 176k they received in 1920 merely offset the losses sustained between 1913-16, and therefore, since there was no net gain on the transaction, no tax should be imposed on the 176k received in 1920.

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b. Holding: Court holds that the 176k received in 1920 is taxable. The Court said that the standard is annual accounting and not transactional accounting. Since the TP deducted 176k in losses between 1913-16, he should be required to report 176k in income in 1920. The result is unfair to TP because it received no tax benefit in the years 1913-16 because they reported net losses; however, for practicality reasons the Court says that annual accounting should be the standard. The Court distinguished the case from Clark by confining that decision to the facts of the case. Problem 1 (pg. 130) 1999 (30k) 2000 30k Tax liability in 2000? -take the loss of 30k in 99 and carryforward to 2000 so no income pursuant to 172(c). Exception to annual accounting rule b/c allows you to take loss in prior year and apply to a future year. Problem 2: Different answer if 30k inc not from govt contract? -relief provided by congress is broader than applied to Sanford and Brooks. Any loss from business can be used to offset income the business earned and doesnt have to be tied to the same conduct. Problem 4: Can taxpayer cherry pick to use losses in higher tax bracket years? -No, Congress has specified that you cant cherrypick, you have to go back two years and then forward in a continous strain, so on these facts youd have to go back to 95 and take 1k loss then and then the 1k in 96 and last 1k in 98. c. Congress Provided Four Forms of Statutory Relief i. Acrrual Method: Congress allows businesses to choose the accrual method of accounting rather than the cash method. N/A in this case because TP was a cash method TP. ii. Long-Term Contract Method: This provision allows TPs who perform work under long-term construction or manufacturing contracts to choose the percentage of completion method to account for profits. N/A because TP did not elect to choose this way. iii. Capital Expenditures: Allows for TPs to use ACRS for capital expenditures. N/A in this case because TPs expenditures were not capital expenditures.

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iv. Net Operating Losses (NOLs): 172(b) Allows TPs to carry over net operating losses two years back from the current year and 20 years forward. 172(c) defines NOLs as the excess of allowable deductions over gross income. This provision would have allowed TP in Sanford & Brooks to carry the net losses sustained between 1913-16 forward for 20 years and thus, allowed them to carry it forward to 1920. Four Examples: (1) TP has a net operating loss of 30k loss in 1999 and gross income of 30k in 2000. What is TPs tax liability in 2000? Answer: 0 because TP can carry the 30k forward 20 years. (2) Does it matter if the 30k received in 2000 in problem (1) is income derived from a source other than the contract? Answer: No because 172(c) says that NOLs are allowed if the excess of allowable deductions exceeds gross income. (3) 2000 Salary 60k Pers. Exemp. (4k) Item. Deduc. (16k) Ord. Loss 0 Net Gain 40k 2001 60k (6k) (15k) (80k) (41k)

How much of the 41k loss sustained in 2001 can be carried back to 2000? Answer: 20k. 172(d)(3)&(4) precludes personal exemptions and itemized deductions from being carried back. (4) TP has a NOL of 3k in 1997 when the tax rate is 25%. Can she carry that loss forward to 1999 and 2000 when the tax rate is 35%? Answer: No. TP must start with the earliest year (1995 because of two years back) and go forward. Since TP had GI of 1k in 95, 96, and 98, the 3k loss is completely absorbed by those three years. No cherry picking of year used to get tax advantages. 25% 95 1000 25% 96 1000 3. Claim of Right a. North American Oil Consolidated v. Burnett 25% 97 (3000) 25% 98 1000 35% 99 1000

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Facts: In 1916, when the tax rate was 2%, the U.S. appointed a receiver to operate property that was in NAOs possession. In 1917, when the tax rate was 6%, the receiver paid 172k to NAO which represented the profits earned from the property in 1916. NAO argued that the 172k was income in 1916 since that represented profits earned in that year. Holding: Court said that the 172k was income to NAO in 1917. The Court said that the TP did not have a claim of right until 1917, and therefore, it should be taxed in that year. Claim of Right Doctrine requires 3 things: (1) TP receives the money (2) under a claim of right and (3) without restriction as to its disposition. The Court said that the company did not have a claim of right in 1916 because it did not have a right to demand that the receiver pay over the money. It was not until 1917 when the receivership was vacated that the company became entitled to the money. There must be annual accounting for practicality purposes. We already closed the books on that year. b. United States v. Lewis (subsequently overruled by statute) Facts: In 1944 Lewis received a bonus of 22k that was improperly calculated. In 1946 a state court ordered that TP had to return 11k of the bonus to the employer. TP wants to deduct 11k in 1944 because the tax bracket was higher. IRS wants the deduction to occur in 1946 when the tax bracket was lower. Holding: Court holds for the IRS and says that the TP should receive a deduction of 11k in 1946 rather than 1944. Annual accounting dictates this result. In 1944, TP had a claim of right so he should be taxed on that amount then. There is no exception under the claim of right doctrine where the TP is later shown to be mistaken about his claim to the money. In the aggregate this approach evens out. c. Congressional Reaction: 1341 (a)(1): If income is included in Year 1 because the TP had an unrestricted right to the money and (a)(2): if a deduction is allowed in Year 2 because it was shown after the close of Year 1 that the TP did not have an unrestricted right to the income, and (a)(3): if the amount of the deduction exceeds 3k then the TP is allowed to choose between:

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(a)(4): the Year 2 deduction and (a)(5): the Year 1 deduction Result: TP wins every time. 1341 OVERRULES LEWIS. IF 1341 HAD BEEN THE LAW AT THE TIME OF LEWIS, TP COULD HAVE CHOSEN TO TAKE THE YEAR 1 DEDUCTION. 4. Tax Benefit Rule a. Generally

TBR arises when the TP claims a deduction in Year 1, and the amount deducted is recovered in Year 2. This is the converse of Lewis (i.e. deduction in Year 1, income in Year 2, whereas Lewis had income in Year 1 and deduction in Year 2). b. Exclusionary Aspect If the deduction did not reduce TPs income in Year 1 (i.e. TP had a net loss, or there is no deduction allowed to the TP), then recovery in Year 2 is not included in TPs income. Unlike 1341, 111 does not protect the TP from marginal rate swings; it just protects the TP if the marginal rate was 0, 111: Under this section, if the deduction does not reduce TPs tax liability, when you get it back in the future it is not income. However, if TPs tax liability is reduced (e.g. 1% tax rate, TP gets $100 and deducts $1), then the recovery is taxed even if the marginal rate is higher (e.g. recovery when tax rate is 99%; TP receives $100, result is tax in amount of $99). c. Inclusionary Aspect Shifts from annual accounting to transactional accounting. Deduct in Year 1; income in Year 2 is tied to the amount of the prior deduction and not the current FMV. Example: TP donates property worth $100 and takes a $100 deduction in Year 1. In Year 2, the property is returned with a FMV of $150. TP only has to claim $100 in income in yr 2. Basis is still $100. 111: Under 111, the income from the return of property equals the amount of the deduction. F. Recoveries for Injuries

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1. Basic Rules a. TPs Who Are Not Individuals: Income includes lost profits, punitive damages, and recovery for loss of profits to the extent that the recovery exceeds basis. i. Lost profits = income ii. Punitive damages = income iii. To property = income to extent>basis b. Individual TPs: 104(a)(2) says that gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or physical sickness. c. Examples: (1) Adam gets into an auto accident and receives 100k for pain and suffering and for lost wages. This is not income because it is received on account of personal injury. (2) Megan recovers 100k for libel. This is income because it is not received on account of personal injury. (3) H sees W hit by a drunk driver. W gets 100k for physical injuries, 50k in medical expenses, and 1 million in punitive damages. Only thing taxable is 1 million. H receives 100k for emotional trauma in witnessing the accident and 10k for psychiatric bills. None of this is income because 104(a)(2) does not say that the person recovering must have sustained the injuries; it just says must be received on account of personal injury. Dennis Rodman example with the camera man: 120K was for physical injury (non-income), 80K was for keeping quiet (income). Lost wages are not taxed. The idea is that the lost physical ability is the basis for getting that money and so it may be deducted. d. 101(a): excludes life insurance proceeds from income. 2. Deferred Payments a. 104 (a)(2): Gross income does not include the amount of damages received whether they are paid as lump sums or as periodic payments on account of personal physical injuries or sickness. i. Also in the same section: exclusion for damages if you are injured rather than killed. b. Result: Huge incentive for tort victims to take structured settlements rather than lump sum because the interest component is not taxed whereas if you receive a lump sum payment, interest is taxed. For instance, if V is offered a choice between $3,791 now or 1k/yr for five years, she should take the latter. If she takes the former, she would need to invest the money in something like an annuity in order to achieve the same financial status. However, her basis would only be $3,791 instead of 5k, so she would be taxed on the excess, which represents the amount

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of interest earned on the investment. 104(a)(2) functions similar to a tax-deferred retirement plan. G. Loans & Discharge of Indebtedness 1. Loans a. Rule #1: Loan proceeds are NOT income to the borrower because it is assumed that she will pay back the loan. This applies whether or not the loan is a recourse loan (TP is personally liable) or a nonrecourse loan (TP is not personally liable) and applies whether or not the TP is on the cash method or accrual method of accounting. Because TP is expected to repay the loan, there is no deduction when she repays it. b. Rule #2: Rule #1 applies regardless of how the TP uses the loan proceeds. c. Example: TP borrows 25k. Income? No because TP is not enriched; the 25k in cash is offset by the 25k obligation to repay. d. Example 2: TP saves 50k and buys IBM stock. She borrows 25k to finance a trip around the world and pledges the stock as a security for the loan. Income? Under the balance sheet theory, no because assets are offset by liabilities. e. E about to earn 100k, borrows 25k to go on a trip: 0 assets, 25k liabilities. i. We dont treat proceeds of a loan as income because we assume that the tax payer is going to pay off the loan. (i) This is true whether the loan is recourse or nonrecourse. ii. Point i applies regardless of how the money is going to be used. 2. Discharge of Indebtedness a. 61(a)(2): Loan proceeds are NOT income to the borrower because it is assumed that the TP will pay back the loan. If TP does not pay it back, 61(a)(12) says that gross income includes income from the discharge of indebtedness. b. Example: T borrows 50k for 3 years at 8%. Interest rates rise, and TP pays off the loan in sixth months for 45k. 61(a)(12) says that TP is required to include 5k in income. c. Loan transaction theory- the loan minus the amount repaid is income. d. United States v. Kirby Lumber Facts: Kirby Lumber issued bonds for sale to the public. They purchased some of these bonds worth 1million on the open market for 862k. Is the 138k difference income?

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Holding: Yes. The difference between the amount the bonds were worth and the amount paid is income to the company. The Court held that since there was no shrinkage of assets, Kirby Lumber realized a gain of 138k. This was illustrated by the fact that the transaction decreased their obligation to pay by 138k. Two Reasons why Kirby Lumber could retire the 1 million in bonds for so much less: (1) The interest rate went up making the opportunity cost of holding the bonds greater (2) Creditors feared that Kirby Lumber would declare bankruptcy so the creditors wanted to get something rather than nothing. Tax Stories: In Kirby Lumber, the court distinguished KerbaughEmpire, which held that there was no income to the TP because the transaction as a whole resulted in a loss. Tax Stories says that Kerbaugh-Empire was decided wrongly for two reasons: (1) it relied on transactional accounting and (2) it links the treatment of loans to the use of proceeds (i.e. different result if Kirby Lumber used the 1 million in a venture that lost 200k). Tax Stories also agreed with the Courts use of the loan transaction theory for deciding the case (i.e. income is the difference between the amount of the loan and the amount paid...therefore Kirby had a clear gain). e. Hypo: TP borrows $100. Loses $10 at the racetrack and repays $90. Income? Under loan transaction theory, yes, income is 10. Under the Courts reasoning in Kirby Lumber/Kerbaugh-Empire, no because overall transaction was a loss and there was an overall shrinkage of assets. 3. Statutory Response 108: If at the time of the discharge of indebtedness, the TP is insolvent, the income from the discharge of indebtedness is excused. Therefore, the result under Kirby Lumber would be the same today because prospect of bankruptcy is not the same thing as actual bankruptcy. 108(a)(1)(E) and (h): discharge of indebtedness on qualified principal residence is excluded form income: - 1m single/2m married - applies if discharge of mortgage is directly related to a decline in the value of the residence 4. Misconceived Discharge Theory a. Zarin v. Commissioner

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Facts: Defendant was a compulsive gambler who received a credit line of 3.4 million at a local casino. Casino accepted payment of 500k in satisfaction of the debt. IRS claimed that Defendant had income in the amount of 2.9 million. 7 Arguments for TP i. 108(a)(1): Gross income does not include any amount that would be included in gross income by reason of the discharge of indebtedness if the discharge occurs when the TP is insolvent. TP says that he is insolvent so DOI should not be included in income. a. No good because Zarin did not raise that argument in the lower courts. He only raised it on appeal. Further, he has assets to pay the law firm, so not really insolvent. ii. 108(e)(5): If the debt of a purchaser of property to the seller is reduced, then such a reduction shall be treated as a purchase price adjustment [rather than income]. (e.g. purchase a car for 50k. Car is a lemon so seller accepts 45k. 5k is not income). TP argues that he purchased property in the form of chips, and therefore, it should be treated as a reduction in the purchase price rather than income. Court does not hold for TP on this ground, saying that chips are not property. iii. 108(d)(1): For purposes of this section, the term indebtedness to the TP means any indebtedness - (A) for which the TP is liable or (B) subject to which the TP holds the property. TP says no indebtedness because gambling debt is unenforceable under NJ law. Court says that 108 DNA; 61(a)(12) controls since we are dealing with income from discharge of indebtedness. iv. Kerbaugh-Empire: Use of loan proceeds resulting in a loss is not income. TP does not win on this ground because Kerbaugh-Empire is no longer good law after Kirby Lumber. v. 104: Excludes compensatory damages from income. TP argues that the casino cancelled his debt to compensate him for preying on his compulsive gambling addiction. He did not win on this ground because he did not receive the discharge as compensatory income. vi. 165(d): Allows gambling losses to offset gambling income. Therefore, TP argued that his 2.9 million in gambling income should offset the 2.9 million in gambling losses. TP did not win on this ground because the gambling income was not in the same year as the gambling losses, and the gambling income was not due to winnings.

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vii.

Broadest argument: No cancellation of debt because 500k is the actual debt: TP argued that the 3.4 million was only worth 500k to him because of his gambling addiction (therefore the actual original loan was 500k). He argued that he did not get normal use out of the 3.4 million. To make things worse, under the IRSs view, the more he lost, the more income he had. TP said that the chips were only worth 500k to him and he repaid the 500k so no income.

Holding: Court invokes the contested debt rule and finds for TP on this ground. Under this rule, where the TP in good faith disputes the amount of the debt, the settlement of the debt is treated as the amount of the debt so no DOI income. (e.g. Bank loans TP money. TP says its worth $50; Bank says its worth $100. They settle for $70. No DOI income because it is contested.). Tax Stories: Tax Stories says that the court got it wrong and this is income. Contested debt rule applies when you contest the amount of the debt, not the enforceability of it. b. Diedrich v. Commissioner Facts: TP were parents who donated $300k worth of stock to their children subject to the children paying the resulting gift tax. The parents basis in the stock was 50k, and the resulting gift tax was 60k. IRS argues that the parents received discharge of indebtedness income in the amount of 10k, representing the difference between the gift tax and the parents basis in the stock. Holding: Court held that there was income to the parents in the amount of the difference between the gift tax and their basis. 3 Alternative Ways to Tax the Transfer i. Gift: TPs argue that they gave their children of a gift worth 240k. The kids pay 60k in gift tax and take the parents basis of 50k in the stock under 1015. Later the stock is sold for 300k. The parents pay no tax, and the kids pay tax on the amount realized basis (300k -50k = 250k). Whats wrong with this is that the children pay 60k and only receive a basis of 50k. ii. Part Sale/ Part Gift, Basis First: The IRS and Court treat the gift to the children as a part sale and part gift. Payment of the gift tax by the children results in 60k realized by the parents. Subtracting out their basis of 50k, the parents realize a gain of 10k. The kids, by paying 60k of the gift tax have a basis in the property of 60k and do

26

not receive any carryover basis. If they sell the stock for 300k, the gain to them is 240k (300k-60k). Thus, total gain is 250k (10k from parents and 240k from kids). Whats wrong with this is that the basis is being allocated immediately (basis first) Part Sale/Part Gift, Pro Rata: This is the best approach. (The basis that is available to the parents should be split based on how much is gift and how much is sale...here there is 80% gift, so 80% of the available basis should transfer along with the gift). It treats the transfer to the children as a sale of 1/5 of the stock and a gift of 4/5 of the stock. The sale of 1/5 of the stock means that the parents realize 60k for a gain of 50k, since the basis is also pro rata (1/5 of 50k = 10k). Parents get 1/5 of the basis, kids get 4/5 of the basis. Thus, upon transfer to the children, the children receive a carry over basis of 40k and are allowed to add the 60k they paid in gift tax to their basis for a total basis of 100k. If the stock is sold for 300k, the kids realize a gain of 200k. The total gain is the same: 250k (200k from parents, 50k from children). 5. Parent own 100 shares of stock with a $200 basis (2/share) and FMV of 400 (4/share). Parents give to their children as long as they pay the $240 gift tax. i. Sale of 60% for $240 ii. 240 amount realized 120 basis (60%) = 120 gain to the parent. iii. Gift of 40% to the children: 80 carryover basis 1. Later sale for 400 2. 400 amount realized 320(240 in tax +80 in carryover basis) = 80 gain c. Background to Tufts i. Depreciation & Basis: Machine costs 5k. Declines in value 1k/year. TP is allowed a deduction 1k per year in depreciation. At the end of 5 years, TP has no basis in the machine. Debt & Basis: If TP takes out a loan in order to finance his purchase of the machine, TP may include the amount of the debt in his basis, regardless of whether or not the loan is recourse or nonrecourse. Debt & Sale Proceeds: If TP sells the machine for 4k and the buyer assumes 1k of TPs debt, the buyer may include the assumption of the debt in his basis. iv.

ii.

iii.

5. Transfers of Property Subject to Debt a. Crane v. Commissioner

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Facts: TP inherited an apartment building with a FMV of 262k and subject to a nonrecourse mortgage of 262k. TP operated the building for 7 years and claimed depreciation in the amount of $25,500 over the 7 years. TP then sold the building for $2,500 cash, and the buyer assumed the 262k of the outstanding mortgage. What is TPs gain on the sale of the property? TPs Approach: TP said that she should only be taxed on her equity in the building plus any cash she received. She conceded that the $2,500 in cash was income. However, she claimed that her equity in the property should be measured by the excess of the FMV of the property less the encumbrance. Since the FMV of the property was equal to the mortgage, she argued that her equity in the property was 0. Therefore, she claimed that the amount realized at the time of the sale was $2,500, and her basis was $0. The TPs approach is inconsistent with her taking depreciation on the property over the past 7 years. It is also administratively impractical. IRS & Court: The IRS and Court said that the amount realized was $264,500 (the amount of cash TP received plus the assumption of the mortgage by the buyer). The Court said that originally the TP had a basis of 262k in the property, which represented the amount of the mortgage, but that her basis should be adjusted downward to reflect the depreciation taken on the property. Thus, the Court ruled that her basis was ($262,000-$25,500= $236,500), and therefore, her gain was $28k ($264,500-$236,500). Tax Stories: This case is important because it led to tax shelters. The IRS won the battle (TP must include mortgage in the amount realized; 28k gain), but lost the war (TPs get to include mortgage in their basis and can deduct depreciation from their income). b. Commissioner v. Tufts Facts: Partnership constructed an apartment complex. The partners financed the project by contributing 45k of their own money and obtaining a nonrecourse loan in the amount of $1.85 million. Over the next two years, the partnership claimed depreciation in the amount of 440k. The partnership sold the apartment building, which at the time had a FMV of $1.4 million, to Fred, an unrelated third party. In return for the property, Fred paid the partnership $250 in cash and assumed the $1.85 million nonrecourse mortgage. 11 Aspects of the Case

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i.

The Partnerships Basis in the Property: Amount of Mortgage + Cash Paid Depreciation = Basis. Thus, $1.85 million + 45k 440k = $1.455 Basis in the property. ii. Why Does Fred Pay $250 for Property Only Worth $1.4 million with an Outstanding Debt of $1.85 milion? Because it is a nonrecourse loan. The bank can call the loan, and since it is nonrecourse, Fred will only be out $250. Amount Realized According to TP: FMV of the property Basis = Gain. Therefore, $1.4 million -$1.455 million = ($55,000). TPs treated the transfer as a sale and therefore, claimed that the amount realized was the FMV on the date of transfer. Amount Realized According to the IRS & the Court: Amount of the Mortgage Assumed by the Buyer Basis = Gain. Thus, $1.85 million $1.455 million = Gain of 395k. The theory is that since TP included the $1.85 million in his basis for depreciation, it must also include the $1.85 million in the amount realized. This makes sense because TP paid 45k in cash and claimed depreciation in the amount of 440k. Therefore, their gain should be 395k. Since we assume that the TP is going to pay back the loan, if they receive a tax benefit and do not pay back the loan, they will be taxed on the tax benefit on the back end of the transaction. v. True Economics View: Allocate the depreciation according to risk; TP can depreciate 45k, and bank can depreciate $1.85 million. The problem with this is practicality: basis will need to be adjusted every time TP makes a monthly mortgage payment. Impact on Tax Shelters Example: TP buys a building for $1 million, and finances the purchase by paying 100k in cash and securing the rest of the building through a nonrecourse mortgage of 900k. TP takes depreciation of 50k/year. After 5 years, TP sells the building for 100k in cash & assumption of the mortgage. Amount Realized Basis = Gain. $1 million 750k = Gain of 250k. OConnors View: (1) Sale of Property = (55k); Amount Realized ($1.4 million) Basis ($1.455 million ) = (55k Capital Loss). (2) DOI = 450k; Loan ($1.85 million) Satisfaction of the Loan ($1.4 million) = DOI income of 450k. OConnor treats the transfer as a sale, so TP realizes a loss. However, she says

iii.

iv.

vi.

vii.

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that by accepting an obligation of $1.85 million for something only worth only $1.4 million at the time of sale, TPs realized 450k in DOI income. viii. Result Today: 7701(g) codifies Tufts: in determining the amount of any gain or losswith respect to any property, the FMV of such property shall be treated as being not less than the amount of any nonrecourse liabilities to which such property is subject. What Is Freds Basis?: (1) $1.85 million: Crane says Fred can include the amount of the debt in the TPs basis. However, it does not make sense to give him a basis of $1.85 million, when it is only worth $1.4 million. (2) $1.4 million: Basis cannot include any amount of a nonrecourse debt that exceeds the FMV when acquired. (3) $0: Debt is not real, so ignore it. This is not a real transaction, so dont give him a basis. Comparison with Zarin: The Zarin Court held that TP did not receive any DOI income from the transaction because the debt was unenforceable. Tufts Court held that TP had DOI even though the debt was unenforceable. The difference is that Zarin got no benefit from the transaction because he was a compulsive gambler, whereas the TP in Tufts received a benefit via depreciation. Avoiding Tufts?: Tufts cannot be avoided simply by giving away the property. Tufts says we dont care about FMV just look at the amount of debt assumed.

ix.

x.

xi.

6. Summary of Loans a. Loan proceeds are not income, whether or not the loan is recourse or nonrecourse because we assume that the loan will be repaid. b. But if the loan is not repaid, Kirby Lumber says that under 61(a)(12), we have DOI income. c. There is an exception to Kirby Lumber under 108(a) which says that if a corporation repurchases debt at less than face value where the corporation is insolvent or in bankruptcy proceedings, there is no DOI income. d. Under Diedrich, where a donee pays a donors gift tax liability, the donor receives DOI income because he was relieved of an obligation to pay taxes.

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e. Crane says that loan proceeds are included in the basis of property acquired with the proceeds because we assume that the TP will repay the loan. This led to tax shelters by decreasing income by claiming depreciation. f. Tufts held that the amount realized on a debt equals the full amount of the property subjected to the nonrecourse mortgage and not limited to the FMV of the property because the loan was included in the basis and depreciated. Tufts is distinguished form Zarin because the TP in Tufts received a benefits from the borrowing whereas the TP in Zarin did not. Cannot get around this by giving away the property because Diedrich says that giving a gift is treated as a realization event. H. Illegal Income 1. Gilbert v. Commissioner (1977)
PROCEDURAL POSTURE: Appellant taxpayer sought review of a determination by the tax court (New York) that he owed income taxes on funds he withdrew without authorization from the corporation he primarily owned. Appellant contended the funds were not for his personal use, but were used to facilitate a merger between his company and another company, that he disclosed the withdrawals, and that he signed promissory notes to the company, secured by his personal property. OVERVIEW: Appellant taxpayer sought review of a determination by the tax court that held that his unauthorized withdrawals from the corporation were taxable income to him. Appellant was the president, principal stockholder, and a director of a company that he desired to merge with another company in order to benefit his company. To facilitate the merger, appellant had purchased shares of the other company's stock, and when he was unable to meet a margin call, he withdrew funds from his company. Appellant testified that he had every intention of repaying and that the withdrawals were not only for his benefit, but for the benefit of the company, and that he had executed secured promissory notes to the company in excess of what was owed. The court reversed and held that appellant had recognized his obligation to repay and had intended to do so. The court held that by signing immediately payable promissory notes secured by most of his assets, appellant's clear intent was to ensure that the company would obtain full restitution. The court held that appellant's net accretion in real wealth on the transaction was zero as he gave the company control of assets more valuable than the debt. OUTCOME: The court reversed and held that appellant did not owe tax on the unauthorized withdrawals he had made from his corporation. The court held that where a taxpayer withdrew funds from a corporation which he fully intended to repay and which he expected with reasonable certainty he would have been able to repay, and where he makes a prompt assignment of assets sufficient to secure the amount owed, he did not realize income on the withdrawals.

a. TP=president and principal s/h of E.L. Bruce Co. Acquired 56% control of Celotex on margin at 30-32/share, Got 2m check from Bruce w/o board approval TP gave Bruce a note and board refused to ratify TPs actions, merger fell apart. b. What does TP do? i. June 1: Returned from Nevada (attending to a personal matter)

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ii. iii. iv. v. vi.

June 12: Flew to Brazil (stayed several months) TP pleads guilty to unlawfully withdrawing funds from corporation IRS jumps in saying embezzled funds=income TP argues it was a loan so no income because he has to pay it back General Rule: Embezzled funds = income: (i) Embezzler by definition does not recognize obligation to repay (ii) No restriction on use (iii) Ct: Exceptions: i. TP withdraws $ from corp which he intends to repay ii. TP reasonably expects to be able to repay iii. TP believes withdrawal will be approved by corp iv. TP makes prompt assignment of assets sufficient to secure amount owed

Note 1: In most embezzlement cases the perpetrator plans to abscond with the money. I. Interest on S & L Bonds 1. Putative Tax: shifting of money from federal government to state government. 2. Is this good policy? Idea is it allows states to determine what projects it wants to borrow for and have a tax subsidy for those projects. 3. There is no perfect equilibrium in the market. a. Todays wall street jrnl showed 30 yr treasury bonds yielding 4.75%, at perfect equilibrium tax exempt bonds should be yielding 3.1% though they are actually yielding 4.35%.

J. Gain on the Sale of a Home 1. Section 121 a. 121(a): Gross income shall not include gain from the sale or exchange of property if, during the 5 years previous to the date of sale or exchange, such property has been owned and used by the TP as the TPs principal residence for periods aggregating 2 years or more. b. 121(b): (1) The amount of gain excluded from gross income under subsection (a) shall not exceed 250k in the case of individuals. (2) For married couples the amount excluded from income is 500k, provided that they both meet the requirements of (a). (3) The TP may only use this exclusion for one sale every two years.

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c. 121(c): Exceptions to the general rule. For certain individuals who are required to sell their homes by reason of change in place of employment, health, or to the extent provided in regulations, unforeseen circumstances, the amount of their exclusion shall not exceed the following: (Maximum allowable amount as determined by (b)(1) or (b) (2)) x [(Amount of time you lived in the home in years) / 2 years]. Hypos: (1) An individual buys a home for 500k and a year later is transferred and sells it for 600k. 121(c)(2) applies, however, the maximum exclusion is allowed. Since the change in value was only 100k, only 100k is excluded from income. (2) Same facts as in (1) except house is sold for 700k. Maximum allowed to be excluded from income is 125k, so 75k is income. (3) W buys house in 1991 for 100k. 2002 W marries H, and H moves into Ws house. 2003, H & W sell the house. W is allowed to exclude 250k from income under 121(b)(1), however, H is not allowed to exclude any because he did not meet the 2 year requirement of (a) which is required in order to qualify under (b)(2). (4) Same facts as in (3) except H moved in with W in 2000, and they got married in 2003. H meets the 2 year use requirement so qualifies under 121(b)(2). Therefore, they are allowed to exclude up to 500k. Since they bought the gain on the house was only 400k though, this is all they can exclude. II. TIMING OF INCOME

Shift from what is income to when is it income. In order for there to be income, the tax law requires two things: (1) that the gain/loss be realized and (2) that it be recognized. 2003- 5% on dividends in the 25% tax bracket, 15% if in the 28-35% tax bracket. Tax law requires that gain/loss must be both realized and recognized. A. Realization of Gains & Losses 1. a. Eisner v. Macomber Realization of Gains Stock Dividends

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Facts: TP owned 2,000 shares in a company with a basis of $100/share for a total basis of 200k. The FMV of these shares was $360/share for a total value of 720k. The company issued a stock dividend, which was akin to a stock split. For every two shares of stock a shareholder had, she received one additional share. Thus, after the stock dividend, TP had 3,000 shares of stock. Therefore, the basis per share was adjusted down to $66.67/share, for a total basis of 200k. The FMV dropped to $240/share for a total FMV of 720k. The IRS sought to treat the value of the 1,000 additional shares as income to the TP. -Stock dividends are not income unless you have the choice between cash and the dividends. 3 Arguments Made by the IRS i. Stock Dividend Increased TPs Wealth: Court says that TPs wealth did not increase because even though she had more shares of stock, the FMV was still the same. Unlike cash dividends, in this case gain was not severed from capital. Here, it was like cutting a pizza into slices, whereas in a cash dividend, it is like getting an extra piece of pizza. ii. Companys Accumulation of Profits Increased TPs Wealth, Realized Through Stock Dividend: Court notes that a companys retained earnings arent taxed to the shareholder even though the company is making money. On the other hand, a cash dividend is taxed to the shareholder because the gain is severed from capital. Court says that a stock dividend is more like retained earnings because the shareholder isnt really any better off with a stock dividend. iii. Companys Accumulation of Profits (Via the Increased Price of Stock), Increased TPs Wealth, and Therefore, Could Be Taxed at Any Time: Should we tax TP on increase in value on 12/31? Fairness says yes because we should tax the FMV increase of $100 in stock the same as $100 in wages. Economics says yes because we do not prefer growth stocks to dividend-paying stocks. However, practicality says no. There are problems of valuation (although it was not a problem in this case) and of having to sell some of the stock to pay taxes. Practicality says you should wait until the stock is sold before taxing the gain. Majority: Gain must not just accrue to capital (i.e. growth of a tree), it must be severed from capital (fruit from the tree). 305: Codifies Macomber. 305(a) says that a stock dividend

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is not taxed. 305(b) provides a list of exceptions, among them a choice between a stock dividend and a cash dividend. Macomber is no longer good constitutional law but is important because it imbedded the realization requirement into tax law. In response to the realization requirement, 1031 is a deferral section that allows some deferment. b. Helvering v. Bruun Facts: TP was a property owner who, in 1915, leased a tract of land with a building on it for a term of 99 years. In 1929, the tenant demolished the old building (which had a FMV of $13k at the time it was demolished) and constructed a new building that had an existing life of 50 years. In 1933, the tenant defaulted on the lease, and the TP regained possession of the land and the new building, which had a FMV of $64k. Thus, the TP realized a gain of $51k. What year should TP be taxed for the gain? Should the TP have realized the gain in 1929? No because the buildings expected life was shorter than the term of the lease. TP: No realization. Under Macomber, gain must not just accrue to capital, it must be severed from it. Since you cant separate the FMV of the building from the FMV of the land, there is no income in 1933. The reason why TP lost is that the lawyer stipulated that the building had a FMV of $64k in 1933. He shouldnt have stipulated to this so that he could show that the value of the property could not be broken down into the value of the building and the value of the land. IRS & Court: TP realized a gain of $51k in 1933. Practicality problems with this ruling: (1) how is TP supposed to pay tax on this $51k? (2) What if TP hadnt stipulated to $64k being the FMV of the property at the time of the transfer? How do you measure the value of the improvement? Hypothetical Landlord gives tenant rent-free use of land for 10 years. The tenant builds a building with a 20 year useful life. The building has a FMV of $400k when it is constructed and has a FMV of $200k when the lease expires and the property reverts back to the landlord. How should we tax this? There are 5 alternatives: Tenant Improvements

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i.

No Rent: TP would argue that because he did not receive any rent, there should be no income. TP likes this option the best because he can defer income until the time the property is sold. Congress agreed and accepted TPs argument in 109. Post-Paid Rent: Approach adopted by the Court in Bruun. Income of $200k to TP in Year 10 when the property reverts back to the TP. Pro-Rated Rent: $20k/year of income for years 1-10. Pre-Paid Rent: Theres a right to property worth $200k in 10 years. Present value of $200k in 10 years at 8% is $92k. TP has income of $92k in Year 1, and $108k in Year 10. Pre-Paid Rent-True Economics: Same has in iv. except that the $108k is spread throughout years 1-10. Option favored by the IRS since it receives the most money up front.

ii. iii. iv.

v.

109: Gross income does not include income (other than rent) derived by a lessor of real property on the termination of a lease, representing the value of such property attributable to the buildings erected or other improvements made by the lessee. 1019: A lessors basis shall remain unaffected where the lessor has received income that is excludable under 109 where the lessee has made improvements to the property while in possession of the property. Applying 109 and 1019 Suppose that when the lessee defaulted on the lease in 1933, the building had a FMV of $50k and had a remaining life of ten years. Also suppose that the lessor rented the property to a new tenant for $7k net of all expenses beginning in 1933. Under Bruun, the TP would have to pay $50k beginning in 1933. TP would be allowed to deprecate $5k a year, with the result being income of $2k/year for 10 years. Thus, the net income would be $70k. 109 and 1019 change this result. Under these provisions, TP does not receive any income in 1933, but at the same time is not allowed to use the additional value of the improvements for purposes of depreciation. Thus, TP cannot depreciate the additional $50k. Therefore, TP has no extra basis and claims income in the amount of $7k/year for 10 years. c. Nonrecourse Borrowing in Excess of Basis

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Woodsam Associates v. Commissioner Facts: In 1922, Mrs. Wood bought property for $296k. Later, she took out an additional mortgage and refinanced these mortgages into a single consolidated mortgage of $325k. Up until this point, she was personally liable for all $325k of the mortgage debt. However, in 1931, Mrs. Wood borrowed an additional $75k and refinanced the mortgage again to create a second replacement consolidated mortgage in the amount of $400k. This second consolidated mortgage was nonrecourse. In 1934, Mrs. Wood contributed the property to the corporation in exchange for the stock. The corporation took Mrs. Woods basis, which it said was $400k, rather than $296k. TPs Argument: TP argues that by executing a $400k nonrecourse mortgage for the property, this was, in effect, a sale of the property for that amount because she no longer had an obligation to repay the loan; she could default on the loan at any time and still gain $104k from defaulting. Therefore, TP argues that when Mrs. Wood refinanced the loan in 1931 into a nonrecourse loan, she had a taxable gain of $104k then. The reason why she argued this is because in 1943, the SOL for 1931 had expired and the IRS could not reach those years. TP then argued that since the $104k should have been income to her in 1931 at the time she became discharged from her obligation to pay, her basis should have been increased because if it was not she would be taxed on the increase again when she sold the property. Since the corporation takes the basis of Mrs. Wood, TP wanted Mrs. Woods basis to be $400k so it could take that as its own basis. Holding: Court held that a nonrecourse loan is not income, and therefore, Mrs. Wood did not receive income in 1931. However, the Court said when a TP disposes of the property, she is required to include in income the amount the nonrecourse loan exceeds her basis. The reason is that the TP got the benefit of the borrowing via cash. Therefore, TPs basis remained $296k. She realized income in the amount of $104k when she transferred the property to the company in 1934, and the company took Mrs. Woods basis of $296k. The IRS won the battle (e.g. kept TP from avoiding tax by holding that the 1931 refinancing was not a sale, and therefore, not income to TP), however, it lost the war by letting future TPs cash-out nonrecourse loans without gain. Example: TP buys property for 100k (financed by $20k in cash and $80k nonrecourse mortgage). TP deducts $5k a year for depreciation for 20 years. At the end of 20 years, the FMV has increased to $200k. TP cashes out by borrowing an additional $100k nonrecourse. TP locks

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in $80k of gain because if the FMV of the property declines, he can walk away and be up the $100k - $20k in cash. There is no tax on this new borrowing, but it is not included in basis either (thereby not allowing TP to use it for depreciation). TP must pay tax when he disposes of the property. 2. a. Realization of Losses Cottage Savings Association v. Commissioner

Issue: Whether or not a financial institution realizes tax-deductible losses when it swaps its interests in residential mortgages with another lenders interests in a different set of mortgages. Facts: Cottage Savings was a savings and loan institution that held numerous long-term, low-interest mortgages that declined in value due to a dramatic increase in interest rates in the late 1970s. The reason why these mortgages declined in value was due to the time value of money. For example, a loan of $100k at 8% and payable in 30 years resulted in monthly payments of $730/month. After interest rates rose to 12%, the FMV of these payments was only equal to $71k. Thus, Cottage Savings would only need to lend $71k in order to generate payments of $730/month. Cottage Savings and other S & Ls wanted to sell these mortgages but were deterred from doing so because of the FHLBBs requirement that they keep separate records of their book losses and tax losses. Therefore, if Cottage Savings sold the $100k mortgage for $71k in order to obtain a tax loss, it would also be required to report a book loss of $29k. If book losses were too high, they would be regarded as insolvent, and so the FHLBB would take over. In order to overcome this problem, the S & Ls sought instead to swap mortgages in order to realize the tax loss but to avoid reporting a book loss. The FHLBB adopted Memorandum R-49 which said that S & Ls need not report book losses associated with mortgages that are exchanged for substantially identical mortgages held by other lenders. 1001: A loss that is triggered by the disposition of property shall be the excess of the adjusted basis over the amount realized. Is a swap a disposition of property? Reg. 1.1001-1: The gain or loss realized from the exchange of property for other property differing materially either in kind of in extent, is treated as income or as loss sustained. Thus, in order for these swapped mortgages to be realized, they must be shown to be materially different.

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Difference Between TP and IRS Positions: TP says that the swapped mortgages are materially different because the loans were secured by different properties. Therefore, materially different standard is met and a tax loss should be realized. IRS says that the mortgages are not materially different. They want the Court to adopt the functional equivalence test; the mortgages are economic equivalents of each other. Therefore, material difference standard is not met, and so there is no tax loss. Holding: Court held that the swapped mortgages were materially different. It adopted the legal entitlements test and said that the S & Ls received mortgages through the swap that they were not legally entitled to had the swap not occurred. This result was driven by the situation. In reality, the swap did not change anything from either the borrowers perspective or the lenders perspective. Court was judicially active to intervene in the financial crisis. Aftermath: IRS is happy that it lost this case because it lowers the threshold for proving realization. Since rules regarding realization apply both to gains and losses, IRS has an easier time proving realization of gains. Reason why they brought this case is because they didnt want FHLBB telling them how to do their job. B. Recognition of Gains & Losses 1. a. Recognition of Gains Like-Kind Exchanges

1031(a): (1) A TP shall not recognize a gain or loss if he exchanges property that is held for productive use in his trade or business or for investment for property of a like kind, and the new property will also be held for productive use in his trade or business or for investment. (2) Lists the property that is excluded under section (a), (e.g. stocks, bonds, and other securities). (3) In order for subsection (a) to apply, the TP must identify the property he is to receive within 45 days of transferring his property, and he must receive the new property within 180 days after relinquishing his own property. Example: Suppose TP owns Property 1, which has a FMV of $100k, and in which his basis is $50k. Also suppose that TP wishes to exchange Property 1 with the owner of Property 2, which also has a FMV of $100k. Absent 1031, TP would be required to recognize a $50k gain. If he is in the 40% tax rate, he must pay $20k in taxes, and thus, is only left with $80k. Therefore, he doesnt have the money to

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buy Property 2. 1031 allows TP to swap Property 1 for Property 2 and to defer the gain by taking $50k in basis in Property 2. 3 Rationales for Nonrecognition in This Instance: (1) Fairness: TP is still in the same business, so should not be taxed because his situation has not changed. (2) Practicality: If gain is not recognized, he might not have enough money to buy Property 2 after paying taxes on Property 1. (3) Economics: Ought to let private individuals decide what is best for their business. (i) Business/Investment Use: 1031(a) is only concerned with the TPs use of the properties. So long as TP plans to use Property 2 for a business or investment purpose, it is immaterial if the owner of Property 2 did not use the land for that purpose. It also does not matter if the other property owner immediately sells Property 1 after the exchange. Like-Kind: Reg. 1.1031(a)-1(b): The words likekind refer to the nature or character of the property and not to its quality or grade. One class of property may not be exchanged for a different class of property. This means that there are different rules for real property and personal property. (A) Real Property 1031(a) allows TP to swap X Farm for Y Farm; Florida farm for a Georgia farm; or land for an office building. However, 1031(a) does not allow TP to swap a farm for a tractor. All real property qualifies (but real and personal cannot be exchanged and still qualify). The exchange must be at the same time...no sale then purchase a week later. Reg. 1.1031(a)-1(c) says that like-kind property includes an exchange for improved real estate for unimproved real estate. Jordan Marsh Co. v. Commissioner Facts: Petitioner owned a parcel of land and had a basis of $4.8 million. In 1944 it conveyed its interest in the land to third-party in exchange for $2.3 million, which

(ii)

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represented the FMV of the property. At the same time, the petitioner leased the newly conveyed property from the third-party for 30 years and 3 days. TP argued that this was a sale, so it should be allowed to recognize a loss of $2.5 million under 1031(a). IRS argued that a 30 year lease is the same as ownership. Therefore, the transfer was a like-kind exchange and not a sale, so there was no recognition of a loss. (Congress: the thing exchanged for had to have a readily realizable market value, Congress was concerned with forcing a realization that was still tied up in investment of the same sort) Reg. 1.1031(a)-1(c): Examples of like-kind property include where TP transfers real estate in return for a leasehold of 30 years or more. Holding: Court holds for TP and says that TP recognized a loss of $2.5 million. Court says that since TP received cash in exchange for real property, the property exchanged was not of a like-kind. Also said that the reg means swap of a leasehold in Property 1 for fee in Property 2 not leasehold for a fee in the same property. Its ok to have some cash involved in the exchange. But in this case, the TP got nothing but cash. (B) Personal Property Reg. 1.1031 (a)-1(b): The words like-kind refer to the nature or character of the property and not to its quality or grade. Reg. 1.1031(a) -2: Personal property is of a likekind if it is of the same class as the personal property for which it is exchanged. List of General Asset Classes: Office furniture and equipment, information systems, airplanes, automobiles and taxis, buses, light general purpose trucks, heavy general purpose trucks, railroad cars, tractors, trailers, vessels and barges, etc. (iii.) Disqualified Property 1031(a)(2) lists disqualified property (stock in trade/property primarily held for sale, stocks, bonds securities, partnership interests, and interests in trusts).

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 1031(b): A TP is required to recognize a gain, which is to be the lesser of the gain realized (which is determined by adding the FMV of the property received and the boot received and subtracting the TPs basis in the old property) or the boot received. Thus, if no boot is received, the amount recognized at the time of the swap is $0. In all other cases, the amount recognized is the lesser of the amount realized and the boot. 1031(c): TP is not permitted to recognize a loss at the time of the exchange even if the TPs basis in the old property exceeds the FMV of the new property plus the boot received. The loss will be recognized when the new property is disposed of. 1031(d): The basis in any new property acquired by this section shall be determined in the following manner: Basis in the old property + Gain Recognized (since loss cant be recognized under 1031(c)) + Boot Paid Boot Received. 3 Examples: TP exchanges property for new property that has a FMV of $100k and boot worth $23k. What is the gain recognized at the time of the transfer, the TPs basis in the new property, and the total gain recognized when TP has a basis in the old property of: (1) $10k (2) $110k and (3) $130k? (1) $10k. Total gain is $113k. The amount realized = FMV of new property ($100k) + boot received ($23k) Original Basis ($10k) =$113k. Gain recognized is lesser of boot recd ($23k) and gain realized ($113k), so gain recognized at time of transfer is $23k. Basis in New Property: Basis in Old Property ($10k) + Gain Recognized ($23k) Boot Recd ($23k) = $10k. Gain Recognized When New Property is Sold: Amount Realized ($100k) Basis ($10k) = $90k. Total Gain: $90k + $23k =$113k. (2) $110k. Total gain is $13k. Amount realized = FMV of new property ($100k) + Boot Recd ($23k) Original Basis =$13k. Gain recognized at the time of transfer is $13k since gain recognized is lesser of gain realized and boot recd. Basis in New Property: Basis in Old Property ($110k) + Gain Recognized ($13k) Boot Recd ($23k) =$100k.

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Gain Recognized When New Property is Sold: Amount Realized ($100k) Basis ($100k) = 0. Total Gain: $13k + 0 = $13k. (3) $130k. Total loss is ($7k). Amount realized = FMV of new property ($100k) + Boot Recd ($23k) Original Basis (#130k) = ($7k). Gain recognized is $0 because 1031(c) says you can not recognize a loss at the time of transfer. Basis in New Property: Basis in Old Property ($130k) + Gain Recognized (0) Boot Recd ($23k) = $107k. Gain When Property is Sold: Amount Realized ($100k) Basis ($107k) = ($7k) loss. Total Gain/Loss = 0 + ($7k) = Loss of $7k. 1031(a)(3): Third Party & Deferred Transactions 1031(a)(3): Allows deferred exchanges so long as TP identifies a replacement property within 45 days after transferring his property to another and receives the property within the earlier of 180 days or the due date of a tax return for the year. Example: Farms X and Y have a FMV of $100k. S wants to exchange X for Y; O wants to sell Y for $100k in cash; B wants to acquire X. In order for S to exchange X for Y without recognizing a gain, he must hold X and Y for a productive use in a trade or business or for investment and X & Y must be of a like-kind. Thus, if S conveys X to B, B pays O $100k in cash for Y, and B transfers Y to S, if S has identified the property to be received (Y) within 45 days of transferring X to B, and S receives Y within 180 days of transferring X, then S is not required to recognize a gain on the transfer. 1031 does not apply where S sells X to B for $100k and uses that $100k to purchase Y from O. The reason is that S is selling X for cash and not exchanging X for Y. 1031(f): Exchanges with Related Persons: Suppose a parent owns Property 1 worth $100k and has a basis of $1k. Suppose that she buys Property 2 in her childs name, and Property 2 has a FMV of $100k, and the childs basis is $100k. If the parent wishes to

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sell Property 1, she can swap Property 1 with Property 2. Therefore, child has a basis of $100k in Property 1. The child can then sell the property for $100k. 1031(f) says that a parent has a gain if the child sells Property 1 within 2 years of the transfer. 2. Recognition of Losses a. 165(a): Allows for any loss sustained during the taxable year. b. Reg. 1.165-1(d): A loss is sustained in the year it is evidenced by closed and completed transactions (actually selling a store if it is and as fixed by identifiable events occurring in such taxable year. Pg. 240 Problems: Airline suffers reduction of flights on same route from 6x a day to 2x, wouldnt qualify for a loss w/in the meaning of section 165 because havent abandoned the route altogether. C. OID (Original Issue Discount) OID refers to the unstated interest in a deferred payment. The rules for OID provide that to the extent that a debt instrument does not provide for current payment of an adequate amount of interest, interest must be accrued (that is, included in current income) by the obligee, regardless of whether the obligee is a cash-method or accrual-method taxpayer. The obligor, on the other hand, is allowed to deduct the amount of interest the obligee is required to accrue. 1. Cash

Suppose a TP purchases a bond for $386 that pays 10% per year and is redeemable for $1000 at the end of ten years. The TP receives no interest for years 1-10, but instead, receives a lump of $1,000 at the end of ten years. The rules on OID say that the amount of unstated interest ($1,000 - $386 = $614) is income to the depositor, and the amount of interest must be included in the obligees income every year. Therefore, after the first year, the obligee must include $38.60 in income, and the lender is allowed to deduct this amount from its income. If there were no OID rules, an accrual method obligor would be allowed to deduct the interest paid each year, while a cash method obligee would not report any income from the interest until year 10. Thus, OID puts a cash method oblige on the accrual method. 2. Property

Suppose obligee sells property to obligor and obligor executes a note in which he agrees to pay the obligee $1,000 10 years from now with 0% interest. How do we know that the property is worth $386 now? Use 1274(d)(1)(A) to

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figure out the AFR to tell us the present value of the note. After using the AFR table, we determine that the note is $386, so the OID is $614. AFR for March 2008: less than three is 2.25, middle is 2.97, and more than nine is 4.27%. Use the PV/FV equation to figure it out. 3. Inadequate Stated Interest

Suppose TP sells property for $1,000 to be paid in a lump sum 10 years from now and agrees to pay 8% interest for 10 years in order to defer payment when the AFR is really 10%. By paying an AFR lower than the true AFR, the TP is attempting to defer 2% of interest per year and avoid paying it until he recovers the $1,000. In order to calculate the OID (which represents the amount of interest impermissibly deferred), we take the PV of $1,000 10 years from now, which according to p. 31, is $386. Next, we take the PV of $80/year (which represents the interest paid) for the next 10 years, which is $491. We add those two figures together to get $877, which is the starting balance to be used in the true economics approach. After you have the starting balance, multiply this by the AFR, subtract out the payment, and this net is the OID. 4. Exceptions to OID Rules 1274(c)(3): OID rules do not apply to: (A) the sale of a farm for less than $ 1 million (B) the sale of a principal residence (C) sales involving total payments less than $250k, and (D) publicly traded debts. However, even if OID rules (character and timing) do not apply, 483 (just character) may apply. Example: TP sells her house (basis of $400k) for $1 million to be paid 5 years from now. OID rules do not apply because it involves the sale of a principal residence. Therefore, TP is not required to report income in Years 1-5. Amount realized 5 years from now is $1 million, total basis is $400k, so total gain is $600k. Since the PV of $1 million 5 years from now is $620k, and basis is $400k, total capital gain is $220k. Therefore, $600k - $220k = $380k, which should be included as ordinary income the year received. 5. Market Discount Kirby Lumber: rise in interest rates lowers fmv of bonds. Unlike OID, just affects character (making it regular income rather than capitol gains), not timing, of gain. 1983: IBM issues 1k 30-year 5% bond 2008: Interest rates now 10%. Look at the Alford thing. 6. Deferred Payment Sales 1. Open Transactions

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Burnet v. Logan Facts: TP owned stock and had a basis of $180k in the stock. She sold the stock in return for $120k now and payments of $9k/year for the next 25 years ($225k). The PV of the $9k/year payments was $100k. IRS: This was a closed transaction in 1916 because the future payments had an ascertainable value. Under the IRSs approach, TP should have reported a gain of $40k in 1916, which was calculated by adding the $120k sum payment with the $100k PV of future payments and subtracting her basis of $180k. The IRS said that for the years 1916-1941, TP should have reported a gain of $5k/year. Since the TP was required to report the PV of the future payments in 1916, the TP was allowed to include this figure in her basis to offset her income from 1916-1941. Thus, under the pro rata approach, she had a basis of $4k/year ($100k/25), and realized $9k/year for a total gain of $5k/year. Thus, total gain was $40k in 1916 and $125k from 1916-41 for a total gain of $165k. TP & Court: TP argued that this was an open transaction, and because the future value of the payments was too uncertain, and therefore did not have a readily ascertainable FMV. She argued that she should be allowed to recover all of her basis before paying any tax on payments received. Under this approach, TP would be allowed to allocate $120k of her basis to offset the $120k realized in 1916. This would leave her with $60k in basis left to be used against the future payments of $9k a year. Thus, for years 1-6, TP would not be required to report any income. In year 7, she would have $6k in basis left and would be required to realize a gain of $3k. For years 8-25, TP would be required to report a gain of $9k a year for a total gain of $165k. 2. Installment Sales

Installment sales are codified in 453 and represent a Congressional compromise between the IRSs closed transaction & pro-rata approach, and TPs open transaction & basis first approach. 453(c): Under the installment plan, income is determined as follows: Annual Payment x (Gross Profit /Total Payments). Gross profit is determined by adding up all of the payments and subtracting total basis. 453(d): TP can elect out to the basis first approach (i.e. is allowed to choose the TP/Court approach in Burnet.) 453(e): TP has a gain if a related party disposes of the property within 2 years. 453 (l): interest charged on deferred tax if greater than 5m.

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Example: Suppose TP sells property that has a basis of $200k and is to receive $100k/year for 4 years. Results under the three approaches: (i) Open Transaction & Basis First Approach: TP is allowed to recover all of her basis before paying tax. Therefore, TP does not recognize income for years 1 and 2 but recognizes $100k in income for years 3 and 4. (ii) Closed Transaction & Pro-Rata Approach: PV of $100k a year for 4 years is $317k. This is income right away. $317k realized - $200k in basis =$117k in income in year 1. Therefore, when receiving the $100k payments for the next 4 years, TP has a basis of $317k since that is the amount of income she has recognized. Under the Pro-Rata approach, her basis should be allocated over the next four years. Therefore, she has a basis of $80k/year ($317k/4). She uses this basis to offset the $100k payments. Therefore, in Year 1, TP reports income in the amount of $137k ($117k + $20k) and reports income of $20k/year for Years 2, 3, and 4. (iii) Installment Sale: Annual Payment x (Gross Profit /Total Payments). Thus, $100k x [($200k /$400k)] = $50k/year. 7. Marriage & Divorce 1. Realization

H & W divorce in a common law state. H transfers stock in which the FMV is $10k and his basis is $1k to his wife, and in return W releases marital rights (e.g. dower and courtsy). Should H be required to realize a gain on the transfer? This is the issue in Davis. (FYI: community property states say H is not required to realize a gain; divorce is not a realization in community property states). a. Gain to a Payor Spouse

United States v. Davis Facts: In 1954 TP divorced his wife. TP was sole owner of 1,000 shares of stock, and under the divorce agreement, he agreed to transfer the shares of stock to his ex-wife in return for her releasing all claims against her husbands property, including rights of dower and intestate succession. Issues: (1) Was the transfer by the husband a taxable event? (2) If so, how much should be taxed?

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6th Circuit: No gain was realized when the property was transferred because the wifes rights of survivorship/dower are incapable of valuation. When H transferred the 1,000 shares in exchange for release of Ws marital rights, W clearly received something of ascertainable value (e.g. the FMV of the stock at the time of transfer), but it is unclear as to the value H received in W agreeing to give up her marital rights. Supreme Court: The transfer by the husband in exchange for the release of marital rights was a taxable event. The Court says that the FMV of the property is equal to the FMV of the rights relinquished since the parties engaged in an arms length transaction. Therefore, TP recognized a gain equal to the difference in the FMV of the stock at the time of transfer (because that is equal to the value of W releasing her marital rights) less his basis. 2 Results: W is to take as her basis the FMV of the stock at the time of the transfer. This result punished the payor spouse....but that depended on the residence of the couple. Aftermath: After this decision, community property states held that transfers made pursuant to a divorce agreement were not realizable events to the transferor, whereas common law states held that such transfers were taxable events. Overruled by 1041(a)! b. Basis to Payee Spouse (i) Farid v. Commissioner Facts: In 1924 Kresge owned stock worth $800k with a basis of $12k (15 cents/share). He agreed to transfer this stock to TP, and in return, TP agreed to marry him and to release her dower and all other marital rights. At the time of the transfer, the stock was trading for $10/share. In 1938, TP sought to sell some of the shares, which at the time were worth $19/share. What is her basis? $10/share or 15 cents/share? TP & Court: TP argues that under Davis, the transfer should have been treated as a sale, and Kresge should have realized a gain of $788k. TP then would have taken as her basis the FMV at the time of the transfer, which was $800k ($10/share). Therefore, the gain realized was $9/share. IRS & Tax Court: The transfer from Kresge to TP in 1924 was a gift, so under 1015, Kresges basis of 15 cents/share should carry over to TP. Therefore, TP should have recognized a gain

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of $18.85/share. IRS said that since Kresge never paid tax on the $788k gain, TP should have gotten Kresges basis when the shares were transferred. Overruled by 1041(b). Tax Stories: Major whipsaw. H did not gain at the time of the transfer, and W took a stepped-up basis. (ii) Congressional Response 1041(a): Overrules Davis. Payor spouse does not recognize a gain. 1041(b): Overrules Farid. Payee spouse takes carryover basis rather than FMV at time of transfer. This is NOT 1015: Under 1015, the payee has to take the lesser of the transferors basis or the FMV at the time of the gift. This only applies to 1041 and not 1015. Under 1015, which applies the basis to gifts, the transferee must take the lesser of the transferors basis or the FMV. Therefore, if transferor has a basis of $200, transfers the property when the FMV is $50, and the transferee sells the property for $50, under 1015 there is no loss, but under $1041, transferee takes a loss of $150. c. Planning What property should payor spouse transfer in a divorce? Property 1 ($50 basis, $200 FMV)? Property 2 ($150 basis, $200 FMV)? Property 3 (200 cash)? Answer: Transfer low basis property (Property 1) because payee spouse is often in a lower tax bracket than payor spouse. Since payor is not required to recognize a gain, he wants to get rid of property with lowest basis. Payee is often in low tax bracket so the amount of tax she will pay (10% of $150 = $15) is far less than tax payor would pay if he sold the property (40% of $150 =$60). 2. a. Rules Alimony: Deductible to payor spouse; income to payee spouse. Child Support & Property Settlements: No deduction for payor spouse; no income to payee spouse. 215-c- H has to report the Ws SS# in order to avoid whipsaw. Alimony v. Child Support and Property Settlements

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 71(b)(1): Defines alimony as: cash (A) paid or received under a divorce/separation agreement (B) arrangement does not specify that the payment is nondeductible (C) payor and payee, if divorced, cannot be living in the same household at the time of payment (D) the payment is terminable at the payees death. Alimony payments must be in writing, and cannot be disguised as child support payments (i.e. provision that payments will stop if child dies). b. Front-Loaded Alimony

71(f) was passed by Congress to ensure that payor spouses dont pay an excessive amount of alimony up front in order to receive the tax benefits associated with deducting such payments. 71(f)(1) provides that beginning in the third year post-separation, a payor spouse is required to report as income any excessive alimony payments. 71(f)(2) limits the term excess payments to the amount of overpayments in the first and second year. 71(f)(3) shows how excess payments are calculated for the first year. The amount of excess payments in the first year is the amount of payment in the first year in excess of the average of the alimony payments made during the second year (reduced by the amount of overpayment) and the amount of alimony paid during the third year plus $15k. Year 1 Excess = Year 1 payment [(True Year 2 payment + Year 3 Payment)/2] 15k. 71(f)(4) shows how excess payments are calculated for the second year. The amount of excess payments for the second year is the amount of payment in the second year in excess of the amount of alimony paid in the third year plus $15k. Year 2 Excess = Year 2 Payment (Year 3 Payment + 15k). True Year 2 Payment = Year 2 Payment Excess. Example: TP makes alimony payments of $60k in years 1 and 2, and $5k in years 3 and 4. First have to figure out excess payment in Year 2. Excess payment in year two is determined by subtracting the sum of the year 3 payment ($5k) + $15k (equals $20k) from the Year 2 payment ($60k-$20k=$40k overpayment). Year 1 overpayment is determined by taking the average of the true Year 2 payment ($20k) and Year 3 payment ($5k) (thus, average is $12.5k) and adding $15k (thus, $27.5k) and

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subtracting this number from the Year 1 payment ($60k-$27.5k=$32.5k). Thus, total overpayments of $32.5k + $40k =$72.5 must be included as income in Year 3. 8. Cash Method of Accounting 1. Cash Method v. Accrual Method

Under the cash method of accounting, the TP reports income when received and reports deductions when paid. On the other hand, under the accrual method the TP reports income when earned and reports deductions when the deduction is incurred. The cash method furthers practicality because it is easier to determine when cash was received and paid out, whereas the accrual method furthers fairness because TP should not be allowed taxed on income until after theyve earned it. 2. General Rules

a. Constructive Receipt The Doctrine of Constructive Receipt says that TP has income when she has an unrestricted right to it. The theory is that a TP should not be allowed to escape tax liability merely by turning her back on income and refusing it until later date once you have an unrestricted right to income you must report it as income. Hypo: 12/31/02 TPs employer sends out a check to TP. TP does not receive the check until 1/2/03. Income to a cash-method TP in 2002 even though money not received until 2003? Yes because TP had an unrestricted right to the money, and therefore, it is treated as income under the doctrine of constructive receipt. Reg. 1.446-1(c)(1)(i): Generally, under the cash method all items which constitute gross income (whether or not they are cash) are to be included for the taxable year in which they are actually or constructively received. b. Cash Equivalence/Economic Benefit Cash Equivalence/Economic Benefit says that a cash method TP who receives non-cash benefits is treated as having received cash equal to the FMV of the non-cash item. CEEB requires that the cash/property be set aside and protected from the transferors creditors. INCOME IF EITHER CR OR CEEB IS SATISFIED Hypo

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Difference between constructive receipt (CR) and cash equivalence/ economic benefit (CEEB) can be illustrated by the following hypo. Suppose Reds put Ken Griffey Jr.s salary in escrow until 2004. Is Griffey required to report income under the CEEB doctrine? Yes because he received the economic benefit in 2003. In addition, since it is in escrow it is fully protected from the Reds creditors, he receives a guaranteed benefit because he is assured of receiving the money. However, he would not be required to report income under the CR doctrine because he did not have access to it until 2004. Amend v. Commissioner Facts: TP was a cash method TP who sold 30,000 bushels of wheat to Burrus in 1944, and under the terms of the contract, Burrus was not to pay until 1945. IRS claimed that TP should have reported income in 1944 because he had an unqualified right to receive payment in 1944 but merely chose to defer payment until 1945. Therefore, under the doctrine of CR, TP had income. TP argued that he did not have an unrestricted right to the income until 1945 and should not be taxed until he had the right to the money. Holding: Court found for TP, saying that TP did not realize income either under CR or CEEB. The Court said that under CR, TP must have an unrestricted right to income. Since TP did not have a right to receive payment until 1945, there is no income under CR. The Court said that courts should not look behind the contract for practicality reasons, and since he did not have a right to receive income in 1944 it is not income. The Court said that TP did not have income under CEEB either because a mere promise to pay is not an economic benefit (i.e. Burrus could have been insolvent). Result Today: TPs sale would now be an installment sale under 453(b) (1) unless he elected out. Since he received 100% of the payment in 1945, the result would not be changed; however, if he elected out, he would be required to report income in 1944. Since A consistently used the cash method, the Court said that it was O.K. for him to report income in 1945. However, had he been inconsistent in reporting income, IRS could have invoked 446(b) and required TP to recognize income in 1944 in order to clearly reflect income. Pulsifer v. Commissioner Facts: TP bought sweepstakes entries on behalf of himself and his 3 kids. They won $48k and the man was sent his share of the winnings ($12k), but did not did pay him the $36k representing his childrens interests.

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Instead, their winnings were placed in an Irish bank and could not be released until the kids reached the age of 21 or their guardian applied for its release. Are the childrens winnings taxable as income now? Holding: Yes. Court says that TPs did have income under CEEB because they had an irrevocable right to receive the money and the payor relinquished control. They dont address the question of whether there is income under CR, but the answer is yes because all they had to do was apply for it. 3. Retirement Benefits a. United States v. Drescher Facts: In 1939, Company purchased an annuity for $5k, naming TP as the annuitant. Beginning in 1959, the annuity was to pay TP $650 a year with a minimum of 120 payments (that is, if he died after 50 payments, his beneficiary would be entitled to receive the remaining 70 payments). Company deducted the cost of the annuity in 1939 (the year it purchased it), as it was on the accrual method. However, TP did not report any income from the annuity in 1939, because he was a cash method TP. IRS argued that TP had $5k in income in 1939 through economic benefit doctrine. TP argued that his income was $0 through cash equivalence theory. Who is right? Holding: Court held for IRS and said that TP received an economic benefit in the year it was purchased, and therefore, was required to report the present value of the annuity in his income for that year. Court says that the policy gave him the right to future compensation so under economic benefit doctrine, he obtained an economic benefit when the policy was issued. Court then says that TP was required to state in his income the value of the annuity to him, which was to be the subjective value of the annuity to TP. Since TP did not prove that the value of the annuity was less than $5k, Court held that he had income in the amount of $5k Result if TP had won: In 1939, TP would not have any income and company would be allowed a deduction. IN 1959, TP would realize income and employer would not be entitled to a deduction. 2 Elements of Annuities (1) Interest: Insurance company receives $5k in 1939, and retains the use of that $5k for 20 years. PV of 5k at 6% for 20 years is $16k.

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(2) Mortality: If TP dies before 1969, TP must only pay $6500 since it agreed to pay a minimum of 120 payments. However, if TP dies at $100, it must pay out $22k. Hypo: What would the result have been if TP had a choice between $5k in cash and the annuity? Answer: income in 1939 under CR because TP had a choice between the cash and the annuity. 4. Deferred Compensation Rev. Rul. 60-31: Employers mere promise to pay is not income to cash method employee. The employer must relinquish control in order for an economic benefit to accrue to the employee. a. Minor v. Commissioner Facts: TP was a doctor who entered into an agreement with his employer whereby employer agreed to place 90% of TPs income in a deferred compensation plan. On his tax returns, TP only included the 10% of compensation he would receive. IRS claimed that the 90% was income because it was a benefit he received in the year in question and should have been taxed in the year it was received. Was this income either under CR or CEEB? Holding: No. Court says and IRS concedes that TP did not have an unqualified right to receive the money in the year in question, and therefore, CR does not apply. Since Amend says that courts will not look to the reasons behind a contract, TP is allowed to enter into an agreement whereby he agrees to receive money later even though he could have demanded payment up front. Court says that TP did not realize income under CEEB because the compensation package was not secured from the employers creditors, and therefore, it could be gone at any time. Ways to structure the NFL deal. 274 - a. Team buys annuity from INs co for 600K to pay player 1m after 5 yrs o this qualifies as income under CEEB because the funds are set aside beyond the reach of the team, but the player has the option to get the 600,000 now. - b. Team puts 600,000 in trust that buys US bonds worth 1m in 5 yrs, & truste directed to pay player in 5 yrs o 600k still income, even though not paid out in five years - c. same as b, except 1m to be paid to the team after 5 yrs to provide funds to pay the player. o 0 income now o 1m in 5 years - d. corp signs unconditional promise to pay player 1m in 5 yrs, secd by personal guarantee of the owner

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o works for tax purposes...two levels of security to the player. 9. Qualified Employee Plans (huge benefit for retirement) a. Tax Advantages (282) (i) (ii) (iii) Employers payments into the plan are not income to the employee. Employer gets an immediate tax deduction. Investment earnings are not taxed until withdrawn by the employee.

b. Requirements of Qualified Benefit Plans (i) (ii) (iii) Anti-Discrimination: Cant offer qualified employee plans to highly paid employees and not offer it to rank-and-file employees. ERISA: Employers must comply with the ERISA rules which regulate the plans in order to ensure the safety of the investments. Penalty for Early Withdrawals: If a person withdraws money from a qualified plan before reaching the age of 59.5, then in addition to being included in income for that year, the TP is subject to a penalty of 10% of the amount withdrawn. Mandatory Distributions: Payments must begin no later than when the TP reaches the age of 70.5 Limitations: Maximum benefit under the plan may not exceed $160k.

(iv) (v)

Because of these requirements, many companies offer top executives nonqualified deferred compensation packages. The cost of offering such packages is that the employer may not deduct any payments into the plan, but the benefit is that they are not subject to the limitations of qualified employee plans (principally, the non-discrimination requirement). 10. 83 & 422: Stock Options, Restricted Property & Other Employee Compensation Hypo: In Year 1, Company gives TP the option to buy 1 share of stock in Year 5 for the price of $8. At the time the option was given (Year 1), the stock was trading for $20. In Year 5, when the stock is trading for $25/share, TP exercises the option to buy the stock for $8. Finally, in Year 10, TP sells the stock for $35. TPs total gain is $27. How much of the gain is realized as income, and how much is realized as capital gain? When should the gain be realized? Three options:

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(i)

Income Upon Receipt of Option (Year 1): Under 83(a), TP is required to include the FMV of the stock option the year the option is granted provided that: (1) TP can transfer the option without restriction and (2) the option is not subject to a substantial risk of forfeiture. For purposes of this section, substantial risk of forfeiture means that an employees right to enjoyment of the property is conditioned on providing future services to the company. However, 83(b) provides that if either of the conditions of 83(a) are not met, TP may elect to include the FMV of the option in income the year the option was granted. If TP includes stock option in income, company is allowed a deduction. If the option lacks a readily ascertainable FMV, (ii) applies instead of (i). Income Upon Exercise of Option (Year 5): Where the requirements of (i) are not met (i.e. TP does not elect not to include as income the FMV of the option when granted), TP must include the FMV of the option as income when exercised. Option (ii) also applies if the stock option did not have a FMV at the time it was issued; this applies even if the FMV becomes ascertainable after the grant but before the exercise. If TP includes the FMV of the option in income, company is allowed a deduction for that amount. Capital Gain Upon Sale of Stock (Year 10): Applies if 422 applies. 422 requires: (1) that TP retains the stock for 2 years after the grant and 1 year after exercising the option (2) the option price exceeds the FMV at the time of the grant (3) the stock option is approved by the shareholders and (4) there is a 100k ceiling on all unexercised options at the date of the grant. The result is that TP reports a capital gain the year of the sale, and the company is not allowed to deduct the FMV of the option from income. The $100k ceiling also limits grants to corporate fat cats.

(ii)

(iii)

Result Under Hypo: Option 1: TP would be required to include $12 (20-8=12) as income in Year 1, since that represents the FMV of the option at the time of grant. The company would be allowed a corresponding deduction. Upon disposition of the stock, she would be required to report capital gain of $15 ($35-$20). Option 2: TP would be required to include $17 as income in Year 5 because that represents the FMV of the option when exercised. The company would be allowed a deduction of $17 in that year. TP 56

would be required to realize a capital gain of $10, the year she sold the asset. Option 3: TP would only be required to realize a capital gain of $27 in Year 10, the year she sold the stock. Option #3 is best for the employee because capital gains taxes are lower than income taxes. This is the worst option for the company because it is not allowed a deduction. Company prefers 1 or 2 because they get a deduction. Cramer v. Commissioner Facts: In 1978, IMED issued to TP an option to purchase 50,000 shares of IMED stock at $50/share. IMED put the following restrictions on the stock TPs exercise of the options: TP could only exercise the options in 20% increments over each of the next five years, had to be employed by IMED in order to exercise the options, and TP could only transfer the stock to persons approved by the Board. TP filed an election under 83(b) due to the restrictions on the stock options, and therefore, did not report any taxable income from receipt of the options in the year of their grant. TPs never exercised their options because in 1982, WarnerLambert bought out IMED and as part of their agreement agreed to pay TP $163/share less the exercise price for each option. Therefore, TPs sold their options rather than exercising them. TPs received $25 million from the options in 1982 and reported all but $1.3 million as capital gain. Holding: Court held that due to the restrictions on the stock options and the fact that TP was required to remain employed with the company in order to exercise the options, the Court held that the stock options had no readily ascertainable value the year they were granted, and consequently, TPs were not required to report their value as income in 1978. Court said that even though TPs never exercised the options, the fact that they sold the options was close enough, and therefore, TPs were required to report the gain as income in the year they were sold. However, even if 83 did apply at the time of the grant, the restrictions and the substantial risk of forfeiture would allow TP to elect to report income in the year the options were exercised (i.e. 1982), and therefore, under 83(b), value of the options should not have been included at the time of the grant. 11. Accrual Method 1. Rules

TPs under the accrual method are required to report income when the income is earned and are allowed to deduct income when an obligation is incurred.

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For purposes of determining when income is earned, Reg. 1.451-1(a) states that income is earned when (1) all of the events which fix the right to receive income have occurred and (2) the amount thereof can be determined with reasonable accuracy. (there is a narrow exception that if there is a substantial prospect of total default, then no income in year 1) For purposes of determining when a deduction is proper, Reg. 1.461-1(a)(2) says that a deduction shall be taken when (1) all of the events that establish a liability have occurred, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. 2. Delayed Receipt: Cash Received Too Late

Georgia School-Book Depository v. Commissioner Facts: TP was a broker who received an 8% commission on all books the State of Georgia purchased through it. The contract between TP and Georgia provided that TP would be paid out of the States Free Textbook Fund. TP was an accrual method TP and in Year 1 purchased books for Georgia. However, the Free Textbook Fund lacked sufficient funds with which to pay TP. TP claimed that it did not earn income in year 1 for two reasons: (1) all of the events which fixed the right to receive income did not occur in Year 1 because TP did not get paid and (2) TP was not assured of payment by the State and therefore, there should be no income until it received payment. General Rule: Accrual method TPs are required to pay tax when they receive the right to receive income. Even if cash is not received until Year 2, if the right to receive income has occurred in Year 1, then there is income to TP. Holding: With respect to TPs first defense (that there was no income because payment did not occur in Year 1 and thus not all of the events that establish liability have occurred under Reg. 1.461-1(a)(2)), the Court says that all of the events which fixed TPs right to receive commissions occurred in Year 1, and therefore, TP received the right to payment in Year 1. Since TP is an accrual method TP, TP realized income in Year 1. With respect to TPs second defense (that payment was not certain), the Court said mere doubt of payment is not enough to prevent accrual of income there must be a substantial risk of default in order for income not to be realized. Since there was no substantial risk of default, TP realized a gain in Year 1. 3. Prepaid Income: Cash Received Too Early

AAA v. United States

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Facts: AAA was an accrual method TP who received cash in advance of services it was required to provide. TP sought to defer payment received in Year 1 corresponding to services it was obligated to perform in Year 2 as income in Year 2. (i.e. customer pays $60 in October for a one year membership. AAA wanted to defer $40 of income representing its obligations for Year 2 as income in Year 2). Holding: Court held that TP realized full amount of income in Year 1 despite the fact that TP used accounting procedures consistent with GAAP. Court reasoned that the legislative history and the lack of proof that the payment was used for services performed in Year 2 were reasons for finding income in Year 1. Thus, the Court effectively put an accrual method TP on the cash method for prepaid income. TP was allowed to deduct its expenses from October-December because it met the three prong test of Reg. 1.461-1(a)(2) (see p. 52). This holding was overruled. See below. Subsequent Developments: a. Rev. Proc. 71-21: IRS promulgated a rule allowing a TP who receives payment in Year 1 in payment for services to be performed by the end of Year 2, TP must report income when the services are performed (so when a certain amount of services is performed, the amount for those services at the time is required to be reported), or by the end of Year 2 whichever occurs first. Thus, the rule allows a TP to report income in Year 2 for cash received in Year 1 if the services are to be performed in Year 1 or Year 2. If the services are to be performed more than 2 years after receipt of the cash, then TP must report the cash as income the year the cash is received. b. 456: Congress overruled AAA by enacting 456. 456 provides that TP is allowed to report pre-paid dues of membership organizations on a pro rata basis over the period the services are to be performed, so long as the services are performed within 3 years after receiving the cash. Schlude: Facts- TP operated Arthur Murray dance studio in Omaha...Customers prepaid fees... - TP allocated income to year in which lessons actually given...Result: Consistent with GAAP...statistically accurate...THERE CAN BE VARYING RESULTS BETWEEN TAX AND GAAP ACCOUNTING...Result is in manipulation, as TP tries to have their cake and eat it too...income for GAAP and no income for tax...Culminating in Enron, WorldCom, Tyco... 4. Deposits v. Advance Payments TPs avoid the result in AAA by claiming that any cash received in advance is a security deposit rather than an advance payment. Advance payments are income; security deposits are not.

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5. Current Deduction of Future Expenses Accrual method TPs can claim deductions for services performed in Year 1 even though they do not get paid until Year 2. 461: An accrual method TP may claim a tax deduction in Year 1 if the following three conditions are satisfied: (1) all events have occurred that establish a liability (2) the amount of the liability can be determined with reasonable accuracy (3) economic performance has occurred. United States v. General Dynamics General Dynamics deducted medical claims where services were performed in Year 1, but claims for reimbursement were not filed until Year 2. The Court disallowed the deduction because all of the events are not satisfied until the claims were filed. Thus, the first prong of 461 was not satisfied. 461 (h): no deduction until economic performance has occurred. 12. Corporate Transactions Hypo: TP is a sole proprietor whose basis in his business is $30k. TP decides to incorporate when the business has a FMV of $100k. When TP incorporates, he has realized a gain of $70k. However, under 351 is gain is not recognized. Similarly, under 1032, the corporation does not recognize a gain. Under 358, TP takes a basis of $30k in the corporation, and under 362, the corporation also takes a basis of $30k. The result is double taxation if both TP and the corporation sells its assets. III. PERSONAL DEDUCTIONS, EXEMPTIONS, AND CREDITS A. Deductions 1. General Overview Standard Deduction: In 2008, the standard deduction for a single TP was $5,450. The deduction for married TPs filing jointly was $10,900. A person has a choice between claiming a standard deduction and claiming an itemized deduction; they may not claim both. Personal Exemption: TP is allowed to claim a personal deduction of $3,500 for every qualifying member of his household. The personal exemption is reduced by 2% (of the original $3500) for every $2,500 that exceeds: $159,950 for a single TP () and $239,950 for married TP (). Thus, if single TP makes $189,500 his personal exemption is $1,830 ($50k / $2,500=20. 20 x 2% =40%. 40% of $3.050 = $1,220. $3,050-$1,220 =$1,830).

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 68: Phase-out of Itemized Deductions: 68 states that itemized deductions shall be reduced by 3% of the amount by which AGI exceeds $159,950. The $159,950 minimum threshold applies to both married and individual TP. Under this section, itemized deductions may not be reduced by more than 20% of that claimed by the TP. 68(c) exempts medical expenses, casualty losses, and investment interests from this rule. Thus, single TP with AGI of $209,950 must reduce his itemized deductions by $1,500 ($209,950$159,950 =$50,000 x 3% =$1,500). 151(d)(3)E- 2008-2009- 33.3% but after that 100% (Bush tax cuts) 2. Casualty Losses a. 165(a): Allows a deduction for any loss sustained during the taxable year. b. 165(c): For individuals, section (a) limits deductions to: (1) losses incurred in a trade or business; (2) losses incurred in any transaction entered into profit, though not connected with a trade or business; (3) (h) losses not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. Casualty losses are those losses defined in (3). c. 165(h): (1) $100 per casualty event is nondecutble. (2) Only the amount of the casualty loss exceeding 10% of AGI is deductible. d. Rev. Rul. 63-232: The IRS has ruled that in order for a casualty loss to qualify under the other casualty, the loss must be comparable to a fire, storm, or shipwreck. Thus, a casualty loss must be: (1) sudden (2) unexpected, and (3) unusual. e. The policy reason for allowing TPs to deduct casualty losses is that they are extraordinary events that reduce TPs wealth, and which TP has no control over. f. Other casualty is meant to distinguish deductible extra- ordinary losses from nondeductible everyday losses. g. Dyer v. Commissioner Facts: Petitioners sought to deduct $100 as a casualty loss under 165 when their vase, valued at $100, was knocked over by their cat. TP

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argued that this was an extraordinary event, and so falls under the category other casualty. Holding: Denied a deduction to the TP. Court said that a pet causing damage to property is not unusual. This is a part of everyday life, and Congress did not intend for 165 to encompass ordinary losses. No longer good law because of 165(h). Reg 1.165-7 b-1- the lesser of the basis or the decline in fmv is what is deductible. A casualty loss has to be sudden, unexpected, and unusual (not commonly occurring). Termites, mold and dry rot do not constitute casualty losses. Not sudden and unusual. h. Hananel: TP left his car on the street in Chicago over Christmas. There was a snow storm, and his car was towed, where it was later compacted. IRS argued that this was not a casualty loss because it is not unexpected that a car would get towed in the winter. Court held that there was a loss because it was unexpected that his car would get compacted. i. Chamales v. Commissioner Facts: TPs were neighbors of O.J. Simpson. After the murders, all of the media frenzy around their neighborhood caused TPs property to decline 30-40% in value. TPs argued that the homicides were a sudden and unexpected event, and as a result, they have suffered a permanent casualty loss. Holding: Court held that this was not a casualty loss. Although the murders were unexpected, the murders, themselves, did not cause a decline in TPs property value; it was the protracted media attention. Thus, the length of the media attention was not a sudden event. Additionally, TPs did not show a permanent loss a temporary decline in market value is not the same thing as permanent damage. Thus, the deduction was denied. No casualty loss deduction if casualty loss is covered by insurance, regardless of whether the taxpayer actually files a claim. - Wears out: no CL - Stolen: CL - Lemon: No CL Hypo: 20k of CL & 100k AGI- 9,900 is deductible (20k- $100, - $10000 (10% of AGI)...this happens one time for each casualty event. TPs are going to try to have losses fit under for profit, or trade-business. If the TP does not file an insurance claim, then there can be no casualty loss deduction. (165 h 4 E)

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j. Casualty Gain: TP has a basis of $5k in a painting. Painting has a FMV of $25k when it is destroyed by fire. TP has an insurance policy paying him $15k. TP recognizes a casualty gain of $10k ($15k-5k). Exception to $100 and 10% rule: losses caused by Hurricane Katrina Blackman- man burning his own house: no CL deduction because the TP was grossly negligent. 3. Medical Expenses a. 213(a): A deduction is allowed for expenses paid for medical care for TP, his spouse, or dependent for amounts exceeding 7.5% of AGI. Policy is to allow a deduction because the expense is an involuntary transaction that reduces personal wealth. The 7.5% minimum threshold is meant to distinguish between ordinary medical expenses and extraordinary medical expenses. b. 213(d)(1): The term medical care means amounts paid (A) for the diagnosis cure, mitigation, treatment, or prevention of disease....d9- no deduction for cosmetic surgery. c. Taylor v. Commissioner: TP had an allergy and was advised by his doctor not to mow his lawn anymore. He paid someone $178 to mow it for him and claimed a deduction under 213 (this was before the 7.5% of AGI requirement was put in place). Court held that TP was not entitled to a deduction. The Court said that there are some expenses are shared by sick and healthy people alike. This was going too far. 4. Charitable Contributions a. Rules Percentage Limitation Property Cash Ord. Inc. STCG LTCG Tang. Pers. Property Public 50% 50% 50% 30% 50% Non-Public 30% 30% 30% 20% 30%/20% Amount of Contribution Public FMV Basis Basis FMV Basis Non-Public FMV Basis Basis Basis Basis

Percentage limitation is in reference to AGI (e.g. for contribution of LTCG to a public company, TP is allowed to deduct the FMV of the LTCG to the extent it does not exceed 30% of AGI).

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 170(d)(1): This section allows a TP who makes a contribution in excess of the limits prescribed in the chart above to carryover the excess into following years. It says that in the case of contributions to public charities, TP may carryover the excess for up to 5 years. Carryover is not allowed for private charities! LTCG- you can carry over for 5 years. Example: TP has AGI of $100k. Makes a cash gift of $80k to public charity. TP is allowed to deduct $50k the first year and is allowed to carryover $30k for the next 5 years. If that same gift was made to a private charity, only a deduction of $30k is allowed with no carryover. Example 2: TP owns LTCG with a FMV of $110k and a basis of $10k. Should he sell it and give the cash to the charity or contribute the property to the charity? Alt. 1: If he sells, he realizes a gain of $100k. Capital gains tax is 15%, so there is $95k left to contribute to the charity. He is in the 35% tax bracket so by deducting the $95k, he saves $33k (35% of $95k). Alt. 2: If he contributes the property to charity, he is allowed to deduct the $110k and give it to the charity. There is no realization event, so he doesnt have to pay CG tax on the $100k. He can deduct $110k and so save $38k (35% of $110k). Result: Thus, by contributing property, charity is better off by $15k, and TP saves $5k in taxes. HUGE INCENTIVE TO GIVE PROPERTY RATHER THAN CASH! Policy- Why have a charitable deduction? This is not involuntary like the other areas of deductions. The policy is that it is good for the government to subsidize the donations that go to charities. b. Ottawa Silica Co. v. United States Facts: TP contributed property to a local government which planned to use the land to construct a new high school. The land was worth approximately $415k and because the school was a donee recognized under 170(c)(1), TP claimed a deduction for the value of the property it donated. IRS argued that the deduction should be denied because TP received a substantial benefit from the transfer of land vis--vis the construction of a road connecting other portions of the TPs land to a main road. Holding: If a donor receives a substantial benefit in making a contribution to charity, the charitable deduction is to be denied. This is not to say that a donor may not receive any benefit incidental benefits

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are O.K., just not substantial benefits. Court said that the construction of the road by the local government was a substantial benefit to the donors, and therefore, the Court denied the deduction. Court said that TP could add its basis of the land it donated to the other land it owned and recover its basis upon sale of the land. Return Benefit: If TP gets back less than he contributes, deduct the excess. Example: TP joins PBS for $50 and receives an umbrella worth $15. TP is only allowed a $35 deduction. c. Overvaluation 170(f)(8): Gets around the problem of overvaluation by requiring a written statement from a charity where TP claims a deduction for $250 or more. 6115- if greater than $75, the charity must provide fmv of any quid pro quo received. d. College Athletics 170(l): This section allows a TP to deduct 80% of a contribution made to a college or university despite receiving the right to purchase tickets for a collegiate sporting event. This overrules Rev.Rul. 86-83 which denied the TP a deduction on the grounds that TP received a substantial benefit from making the contribution. e. Religious Benefits & Services Rev.Rul 70-47: Allows TP to deduct pew rents, building fund assessments, and periodic dues paid to churches. This ruling does not allow a TP to deduct the cost of tuition to a parochial school because services were received in return. Cant receive services in return and still call it a contribution. f. Voluntariness Forced contributions (i.e. where drug dealer is ordered to pay money to a school fund or where real estate developer is required to donate land to the city as a condition for getting the job) are not deductible. 5. Interest a. Personal Interest

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 163(h)(1): Interest is not deductible if it is personal interest (e.g. borrow $35k at 5% to buy a new car. Personal interest so not deductible). b. Student Loan Interest 221: TPs are allowed to deduct up to $2,500 per year for interest resulting from student loans. This amount is phased out when an individual TPs AGI exceeds $50k and in the case of married TPs, when AGI exceeds $100k. c. Qualified Residence Interest (i) Acquisition Indebtedness: 163(h)(3)(B): Allows a TP to deduct the interest incurred on the first $ 1million of a loan that is used to (i)acquire, construct, or improve a qualified residence, (ii) provided that the loan is secured by the residence. (ii) Home Equity Indebtedness: 163(H)(3)(C): Allows a TP to deduct the interest incurred on the first $100k of a loan that is secured by the TPs qualified residence provided that the loan is not in excess of the FMV of the house. (iii) Qualified Residence: 163(f)(4)(A): A qualified residence is a TPs principal residence plus one other residence. The $1 million limit for acquisition indebtedness and the $100k home equity indebtedness is a total limit and does not apply for each residence. d. Hypos a. b. Borrow $500k to buy a house. All interest is deductible under 163(h)(3)(B). Borrow $1.5 million to buy a vacation home. Vacation home qualifies as a qualified residence. Allowed up to $1 million under 163(h)(3)(B) and $100k under 163(h)(3)(C) for a total of $1.1 million. There IRS has published a statements saying that this is true, contrary to some case law out there that says that the $100k from (h)(3)(C) cannot be used to acquire property. 1998: borrow $500k to buy a house. 2003: house is worth $ 1 million. Borrow $ 1 million and refinance. All $500k is deductible in 1998 because it was use to acquire the house.

c.

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However, only $100k is deductible because the loan was not used to acquire, construct, or improve the house so 163(h)(B) does not apply. e. Tracing Interest is allocated according to the use of the loan proceeds. Thus, interest on a loan used for personal purposes is characterized as personal interest. If TP buys a car for $50k using his savings and the next day borrows $50k to start a business, the interest is associated with the business and therefore, is deductible. Had the situation been reversed and TP used the loans to buy the car, it would have been personal interest, and therefore, not deductible. 6. Taxes 164: TP is allowed to deduct state and local income and property taxes from income. This does not apply to state and local sales taxes or user fees. B. Exemptions a. 151: TP is allowed to claim a personal deduction of $3,500 for (a) himself (b) his spouse, and (c) any dependents and deduct that amount from income. The policy reason behind 151 is that there is a feeling that some minimum amount should be excluded from a person/familys income. 151(e): Child of divorced parents is treated as the dependent of the custodial parent unless the custodial parent waives that right. b. Who Is a Dependent? In order to qualify as a dependent, the dependent must: (1) be related to the TP by blood, marriage, or adoption (2) derive over half of his support from the TP (3) have a gross income of less than the exemption amount ($3,050) unless the dependent is the TPs child and is either under the age of 19 or is a student under the age of 24. The exemption is available to a parent no matter if child is born on 1/1 or 12/31; exemption is not done pro rata. Look at p 390 for who is a dependent. Which parent? who child lives with more...tie goes to parent with greater AGI. IV. MIXED BUSINESS AND PERSONAL DEDUCTIONS 162(a): There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. 183: If the TP does not engage in an activity for profit, TP may only claim deductions that are allowable regardless of profit motive. Thus, 183 does not allow TPs to deduct losses

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arising from TPs hobbies. Section (d) says that there is a presumption of a profit motive if the TP has realized a profit for 3 out of the past 5 years. 212: In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year (1) for the production or collection of income, or (2) for the management, conservation, or maintenance of property held for the production of income. A. Controlling the Abuse of Business Deductions 1. Hobby Losses a. Nickerson v. Commissioner Facts: TP bought a farm which was in a run-downed condition and incapable of producing a profit at the time of purchase. TP intended to improve the land over the coming years and eventually, intended for the farm to generate a sufficient amount of income for him to live on. TP did not expect to make a profit from the farm for approximately 10 years and as a result, claimed losses sustained in operating the farm for the years immediately after the purchase. IRS & Tax Court: The Tax Court found that the TP did not engage in farming in order to make a profit. Therefore, because this was not a deduction regardless of profit motive, the Tax Court denied TP a deduction based on 183. TP & 7th Circuit: 7th Circuit reversed, finding that TP did engage in farming in order to make a profit. Therefore, it allowed the deduction. 7th Circuit said that the test was a subjective test TP must have a bona fide expectation of profit. Courts should not consider whether or not TPs expectation is reasonable. Instead, they should only consider whether or not it is sincere. However, in considering TPs primary purpose, courts may consider objective factors (e.g. time expended, amount of income from the activity in the past, etc.). 7th Circuit said that Tax Court erred because it only focused on TPs current expectation of profits, rather than TPs future expectation of profits. Since TP expected to make profits in the future and this belief was sincere, a deduction was proper. P 405- lists the elements that will determine whether it is for-profit- 183 says the standard is that it is a way of life Three categories of farmers: true farmer- can deduct...tax farmer- (469)...hobby farmer- may not deduct because it is a personal expense. Daily case came out the other way...there was a floating expectation of profit and therefore there was no bona fide expectation of profit. b. Westphal v. Commissioner Facts: TP was a tax attorney who started her own practice shortly after graduating from law school. In the early years of her practice, she sustained losses. She

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attributed this to a low client base, cautious billing, and being away from her practice to care for her dying mother. During the years in question, TP claimed losses in the amount of $102k. Her husband, on the other hand, had an income of $2.6 million. IRS claimed that TP was practicing tax law as a hobby, and that her practice was set up as a tax shelter to offset her husbands income. Holding: Court held that TP was entitled to deduct the losses. They said that TPs objective was to make a profit, and that it is not uncommon for a young lawyer to suffer losses in the early years of her practice. c. Application of 183(b) Hobby Losses Hypo: Suppose a race car driver earns an income of $5k, and his expenses are ($2,500k) casualty loss, ($1,300) in gas, oil, and repairs, and ($2,500) depreciation on the car. If TPs motivation for driving racecars is pleasure and not for profit, how much of his $6,300 in expenses can he deduct? Tier 1 Deductions: Deductions that are allowed without regard to whether the activity is engaged in for profit. Thus, TP can deduct $1,900 under Tier 1 deductions ($2,500 in casualty loss to the extent that it exceeds 10% of AGI less $100/event. AGI =$5,000, so amount of casualty loss that is deductible is $2,500 - $500 - $100=$1,900). Includes: Casualty loss, real estate taxes, etc. Tier 2 Deductions: Allowed if for-profit and does not result in an adjustment of basis. Ceiling for Tier 2 deductions is Gross Income ($5k) Tier 1 Deductions ($1,900k) = a total cap of $3,100. Tier 2 deductions are $1,300. The lesser of the cap and the deductions is allowed, so total amount of Tier 2 deductions is $1,300. Tier 3 Deductions: Allowed if for-profit and results in an adjustment of basis. Ceiling for Tier 3 deductions is Gross Income ($5k) Tier 1 and Tier 2 deductions ($3,200) = $1,800. Total Tier 3 deductions are $3,100 ($2,500 represents deduction due to depreciation, and $600 represents the amount of the casualty loss that could not be deducted under Tier 1). Thus, Tier 3 deductions are the lesser of the amount claimed and the ceiling, so total deductions under Tier 3 are $1,800. Therefore, total deductions are $5,000. This is the amount of income that TP earned from the activity. The theory is that since it is a hobby, a TP should only be allowed to deduct expenses from the activity up until income earned from that activity. Thus, if income was 0, then TP would only be allowed a deduction of $1,900 representing the amount that can be deducted regardless of profit-motive. 2. Vacation Homes Four Categories a. No Personal Use

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If TP does not use the residence for personal reasons, then 280(A) does not apply. Thus, you have to determine profit-motive. If there is a profit-motive, then 162 and 212 allow TP to deduct fully his expenses. If TP does not have a profit-motive, but instead rents it out as a hobby, then 183 applies. Example: TP rents out his vacation home for 100 days and receives $8,000 in rental income. TP incurs costs of $2,000 in real estate taxes and $10,000 from depreciation and maintenance. TP never uses the vacation home for personal reasons during the year. How much is he allowed to deduct? Answer: Because TP gets no personal use out of the vacation home, 280(A) does not apply. The result is that he is allowed to deduct all $2,000 of the real estate taxes under 164 and all $10,000 in depreciation costs under 167. Thus, TP realized a loss of $4,000 (Gross income expenses). b. High Rental Use, Very Little Personal Use This section applies if TP uses the residence for less than 14 days, or if used for more than 14 days, TPs use is less than 10% of the days the residence was rented out. 280(A)(e) applies to this category, and says that TP may deduct his Tier 1 expenses in full, and may deduct his Tier 2 and 3 expenses pro rata, which is determined by dividing the rental use by total use. Example: TP uses a vacation home for 5 days and rents it out for 95 days. He receives $8,000 in rental income. He must spend $2,000 in real estate taxes, and $10,000 in depreciation and maintenance expenses. How much is he allowed to deduct. Answer: This category applies because TP used the home for less than 14 days. Therefore, all $2,000 in real estate taxes are deductible because they are Tier 1 expenses, and TP may deduct 95/100 = 95% of his Tier 2 expenses ($10,000), which equals $9,500. Thus, Income ($8,000) Deductions ($11,500) = ($3,500). c. High Personal Use, Very Little Rental Use This section applies if the residence is rented out for less than 15 days, and TP used the residence for personal reasons for more than 14 days, or if used less than 14 days, for more than 10% of the days it is rented out. Under this scenario, any income received from rental use is treated as a de minimus benefit and is excludable from income. TP is allowed to deduct Tier 1 expenses in full, but as a consequence for not having to include rental income in income, TP is not allowed to deduct any Tier 2 or 3 expenses.

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Example: TP uses vacation home for 60 days and rents it out for 10 days. Income is $8,000 and real estate taxes are $2,000 and depreciation expenses are $10,000. How much can TP deduct? Answer: None of the income is included in income. All of the real estate taxes are Tier 1 expenses and so, are fully deductible. However, none of the depreciation/maintenance expenses are deductible because they are Tier 2/3 expenses. Therefore, TP is allowed to deduct $2,000 from income. d. High Personal Use, High Rental Use This section applies if the residence is rented out for 15 days or more, and TP used the residence for more than 14 days, or if used less than 14 days, for more than 10% of the days it is rented out. Under this scenario, TP is allowed to deduct fully his Tier 1 expenses and is allowed to deduct his Tier 2 and 3 expenses pro rata. Tier 2 and 3 deductions are capped at (Rental Income) (the Pro Rata Share of Tier 1 expenses)! In determining the Tier 2 and 3 caps, the IRS and the Courts differ as to the formula used in the pro rata calculation of Tier 1 expenses. IRS says that the formula should be (Rental Use) / Total Use. Courts use the formula (Rental Use) / 365. Example: TP uses vacation home for 15 days and rents it out for 85 days. TP receives income of $8,000 and must pay $2,000 in real estate taxes and incurs depreciation and maintenance costs of $10,000. How much can he deduct? Answer: Use this category because TP uses it for more than 14 days or 10% of days rented out, and the vacation home was used for more than 15 days. Step 1: Deduct Tier 1 expenses in full. Thus, $2,000 is deducted as Tier 1 expenses under 164. Step 2: Deduct Tier 2 and 3 expenses pro rata. Under both the IRS and Courts approach, use the formula (Rental Use) / (Total Use) for this step. Thus, 85/100 = 85% x $10,000 = $8,500 = pro rata deduction of Tier 2 and 3 expenses. Step 3: Allocate the Tier 1 deductions to rental use via pro-rata approach. (i) IRS approach: [(Rental Use) / (Total Use)] x Tier 1 Deductions (Gross Income) (Pro Rata share of Tier 1 expenses) 85/100 = 85% x $2,000 = $1,700.

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$8,000 - $1,700 = $6300 Tier 2 and 3 Cap Thus, total deductions = Tier 1 deductions + Tier 2 and 3 deductions So, $2,000 + $6,300 = $8,300 in total deductions Therefore, TP can claim a loss of $8,000 -$8,300 = ($300). (ii) Courts approach: [(Rental Use)/365] x Tier 1 Deductions (Gross Income) (Pro Rata share of Tier 1 expenses) 85/365 = 23% x $2,000 = $466. $8,000 - $466 = $7,534 Tier 2 and 3 Cap Thus, total deductions = Tier 1 deductions + Tier 2 and 3 deductions So, $2,000 + $7,534 = $9,534 Therefore, TP can claim a loss of $8,000 - $9,534 = ($1,534) 3. Home Offices 4. 280A(c)(1): Allows a TP to deduct from income items allocated to a portion of the TPs dwelling which is exclusively used on a regular basis (A) as TPs principal place of business for any trade or business of the TP (B) as a place of business which is used by patients, clients, or customers in meetings or dealings with the TP in the normal course of TPs trade or business, or (C) in the case of a separate structure which is not attached to the dwelling unit, in connection with the TPs trade or business. a. In the case of an employee, CHECK THE DIFFERENCE. Commissioiner v. Soliman: Listed three factors to determine TPs PPOB: (1) the relative importance of the activities performed at each location, (2) the place where the services are rendered or where the goods are delivered, (3) and finally, the time spent at each location. b. Popov v. Commissioner Facts: TP was a professional violinist who worked for 24 employers in 1993 and recorded in 38 different locations that year. None of these employers provided her with a place to practice. TP practiced 4.5 hours a day in the living room of her 1 bedroom apartment, which she shared with her husband and four-year old daughter. TP claimed a home office deduction for their living room and deducted 40% of their rent from their income. IRS & Tax Court: IRS argued and Tax Court held that TP was not entitled to a home office deduction because the concert halls and recording studios were her PPOB not her living room.

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9th Circuit: The 9th Circuit applied the three prong test in Soloman. However, it found that the second prong was not useful in deciding the case and declined to apply it to these facts. Next, the court looked at the first prong but found that it did not produce a definitive answer. In applying the third prong to the facts of this case, the court determined that TP spent significantly more time practicing at home than she did performing or recording. As a result, it found that TPs PPOB was in her living room and not the recording studios. Therefore, the 9th Circuit held that a home office deduction was proper. Problems with Courts Holding: (1) 280A(c)(1) requires that the portion of TPs home be used exclusively for business purposes in order for TP to receive the deduction. Was TPs living room used exclusively by TP for practicing her violin? (2) The first prong of Soloman supports the IRSs position. Why did the court discard it so easily? c. Three Hypos (1) TP is an associate who works nights and weekends in a study at home. Half the time he uses the office for work, and have the time he uses it for personal reasons. Deduction? No because it is not exclusively used as a home office. (2) Associate uses the study 100% for work. Deduction? No because PPOB is at the law firm not the study. (3) Associate meets clients in her study. Deduction? No because even if she regularly meets clients in her study, her PPOB is still at the firm. 5. Office Decorations a. Henderson v. Commissioner Facts: TP purchased items which she used to decorate her office. She claimed that these purchases were ordinary and necessary business expenses and therefore deductible under 162. IRS & Court: Said that these were nondeductible personal expenses under 262. Court said that 262 trumps 162, and therefore, denied TP the deduction. 6. Cars and Computers 280(F)(b): says that certain listed property (e.g. cars, computers, cell phones, etc.) that is used less than 50% for business can be depreciated via straight-line depreciation. 280(F)(d)(3): Where a TP uses certain listed property, the business use requirement is not met unless it is used for the convenience of the employer and

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is required and is required as a condition of employment. This condition cannot be met merely by employer writing into TPs contract that it is a requirement of the job; more is needed. B. Travel and Entertainment Expenses 1. Pre- 274 Old Law: Meals are deductible only to the extent they exceed the cost TP would have spent anyway. But how do we reconcile this with 162(a) which allows a deduction for all of the ordinary and necessary expenses paid or incurred in carrying on a trade or business? Rudolph v. United States Facts: Insurance company held a convention in NYC for its top selling agents and their wives and paid all of their expenses in order to attend the convention. TP deducted the cost of the trip on the theory that it was an ordinary and necessary business expense that qualifies under 162. District court denied the deduction, finding that the trip was primarily a pleasure trip as compensation for a job welldone. Accordingly, the court held that the value of the trip was non-deductible, and TP was required to include the value of the trip in income. Court: Upheld the district courts finding that this was intended to be compensation for a job well-done, and therefore, was income to TP. Dissent: It was good business to spend money on a convention for its leading agents and give them the opportunity for group discussion and exchanges of experience. 2. 274 a. 274(a)(1)(A): Relationship between Expense and Business Purpose In order to deduct an item as an entertainment expense, TP must establish that (1) the item was directly related to the active conduct of TPs trade or business or (2) in the case of an item directly preceding or following a substantial and bona fide business discussion that such item was associated with the active conduct of TPs trade or business. Question: What if a law firm buys season tickets to the Reds. 75% of the time the tickets are given to clients; the other 25% of the time, the tickets are used by the attorneys. Do attorneys have to claim the value of the tickets as income? Answer: If the primary purpose is to use the tickets for the clients, then 274(a) (1)(A) says that attorneys do not have to include the value of tickets in income.

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b.

274(n): 50% Limit for Meal and Entertainment Expenses 1980: Government paid 70% of the meal. Thus, if TP eats a meal alone, and the meal cost $50, he would be better off taking a client out to lunch in order to receive the deduction. The cost of both TP and his clients meal would be $100. But he would be allowed a 70% deduction. Therefore, the after tax cost would be $30, and TP would be $20 better off if he brings client out to eat. 2003: Government pays 17.5% of the meal. Therefore, if TP eats alone, the cost is $50. If he brings a client out to eat, the cost of the two meals is $100. If TP is only allowed a 17.5% deduction, the after tax cost is $82.50, so TP would have a disincentive to take client out to lunch. Reciprocal Agreements: The cost of eating alone twice is $100. The cost of eating out with client twice is $82.50 per time, then if TP pays for lunch once, and client pays for lunch the other time, TP has an incentive to eat out with client twice and pay once. c. 274(d): Substantiation In order to receive a deduction for meal, entertainment, or other travel expenses, TP must provide records in order to substantiate the amount, time, place, business purpose and business relationship to the person being entertained. The result: pay with a credit card.

3. Business Lunches a. Moss v. Commissioner Facts: TP was a lawyer who met the other members of his firm every day for lunch in order to discuss the progress of their cases. The lawyers ate at the same diner every day because it was cheap and near the courthouse, and they chose to discuss business at that time of day because the alternatives of 7 A.M. and 6 P.M. were less favorable to their schedules. TP sought to deduct the cost of his portion of the meals as a business expenses. 7th Circuit: The 7th Circuit denied TPs a deduction on the grounds that the lunches were not necessary business expenses. The court found that although combining lunch with business might have been most convenient for TPs, it did not follow that it was therefore necessary to do so. To allow TPs to claim a deduction would be to encourage people to combine business with lunch which is unfair to people who cannot arrange their schedules that way. The frequency with which TPs claimed business meal deductions seemed to dictate the result here they did not want to allow TPs to be able to claim every meal as business deductions.

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Alternative: Should TPs be allowed to deduct the cost of the meal in excess of its personal value to them? Economically, this would seem to be right, but it is impractical to place a dollar amount on the personal value TP receives from a meal. 4. Entertaining Customers a. 274 (m)(3): This section disallows a deduction for the travel expenses of a spouse or dependent unless TP can show: (A_ that the spouse or dependent is an employee of the TP, (B) the travel of the spouse/dependent is for a bona fide business purpose, and (C) such expenses would otherwise be deductible by the spouse/dependent. b. Danville Plywood Corp. v. United States Facts: TP sent out invitations to its current and potential customers inviting each customer to send two individuals on its behalf to attend an all expenses paid trip to the Super Bowl. TP asked that the customers send individuals with decisionmaking authority. It was the TPs intent to discuss its products informally with the customers representatives in the hope that the customers would seek out TPs business in the future. Thus, TP did not schedule any meetings or speakers for the weekend. TP claimed a deduction on its tax return in the amount of $100k, representing the cost of the trip. It asserted that it was entitled to a deduction under 162, claiming that the trip was an ordinary and necessary business expense in furtherance of its business. Holding: Court denied the deduction. With regard to the deductibility under 274 of the spouses and dependents of the companys employees, the Court said that before you can even consider the deductibility of those expenses, you need to look at 162. The Court found that TP failed to show that the primary reason for the trip was for business purposes. It arrived at this result by noting that there were no meetings that the participants were required to attend, no speakers, no literature distributed about TPs products, etc. Therefore, it concluded that TP failed to show that the trip was undertaken for business reasons rather than for personal reasons, and therefore, the Court denied the deduction without even reaching the question of whether those expenses were deductible under 274. However, even if TP successfully showed that the trip was undertaken for business purposes, the deduction would still most likely be denied under 274 because on the existing facts, it does not appear as if there was a substantial or bona fide business discussion. C. Child-Care Expenses 1. Smith v. Commissioner

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Facts: TPs were husband and wife who both worked. They employed a nanny to take care of their children while they were at work and sought to deduct the amount they spent on child care as expenses that are ordinary and necessary for them to carry on their trade or business ( 162). TPs argued: but for child care, they could not both work. Therefore, child care expenses were a necessary expense for them to both work. Court: Court denied the deduction, claiming that TPs decision to employ a nanny in order for them both to work was a personal expense, and therefore, was explicitly prohibited under 262. Court also said that under TPs rationale, TPs could claim deductions for food and shelter expenses because but for food and shelter you could not work. 262: Except as otherwise provided, TP is not allowed to claim a deduction for personal, living, or family expenses. Result: If TP is offered a job at $25k and is in the 35% tax rate due to her husbands income, her net income is $16k. If it costs $20k/year to employ a nanny, the TP is $4k a year worse off if she works. Therefore, Smith provides a disincentive for stayat-home spouse from entering the work force. 2. Congressional Response a. 21: 21 provides a child care tax credit, which is a percentage of household expenses. The credit is capped at $3k for one child and $6k for two or more children. The credit is on a sliding scale, so as income rises, credit declines. if you make less than 15k, the credit is 35%, and it drops 1% per 2k down to 20% (at more than 45 k)...you also have to give the SS number of the provider so that they can report on their income taxes. b. 129: Allows an employer to make available to employees, free of tax, up to $5k a year for child-care expenses through a dependent child care assistance program. Either 21 or 129. c. Comparing 21 and 129: TP is only allowed to choose one of these options. TP will choose 21 if her tax rate is lower than the credit rate, and TP will choose 129 if her credit rate is lower than her tax rate. D. Commuting Expenses a. 162: TP shall be allowed a deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business including (2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in pursuit of a trade or business. For purposes of this paragraph, a TP shall not be treated as being temporarily away from home during any period of employment if such period exceeds one year.

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b. Commissioner v. Flowers Facts: TP has a house in Jackson, MS, and his place of business is in Mobile, AL. TP sought to deduct the cost of traveling between the two cities. TP claims that his home is in Jackson, and that his place of business is in Mobile; therefore, he argues that he should be allowed to deduct the cost of traveling between the two cities under 162 since he is traveling away from home in the pursuit of his trade or business. IRS & Court: The IRS and the Court said that TPs home was in Mobile, and that his business was in Mobile. Therefore, they said that he was not entitled to a deduction because by going from his home in Mobile to work in Mobile, he was not traveling on business any more than a person in Mason travels to Cincinnati to go to work. Court adopted a three part test. In order for the expense to qualify as a traveling expense entitling the TP to a deduction under 162, the expense must be: (1) reasonable and necessary, (2) incurred while away from home, and (3) incurred while in the pursuit of a trade or business. Court said that TPs expenses failed (3) because the travel was motivated by TPs personal preference to live in Jackson. The Court said that this was similar to a long distance commute, and the duplication of expenses was TPs personal choice. Dissent: Dissent said that Jackson was clearly his home not Mobile. Therefore, by traveling from his home in Jackson to Mobile for business purposes, his expenses were within the realm of 162, and therefore, he should be entitled to a deduction. c. Hantzis v. Commissioner Facts: TP was a law student who lived in Boston with her husband. She was unable to find a summer job in Boston, but instead, found one in NYC. She sought to deduct, as traveling expenses, the cost of transportation to NYC, her meals while there, and her lodging on the theory that her home was still in Boston, and therefore, these were costs incurred while away from home and in pursuit of a trade/business. As a result, she claimed that these were deductible traveling expenses under 162(a) (2). IRS & Court: IRS and Court said that TPs home during this time period was NYC, and her place of business was also NYC. Therefore, the Court denied TP a deduction because she was never away from home when these costs were incurred. The Court says that it was a personal choice to find work in NYC, and it was a personal choice to keep a home in Boston. Although her husband lives and works in Boston, only he has a business reason to live in Boston; TP doesnt. Courts will look to whether the reason for the travel is personal or business exigencies. Is there a business related reason to call another city home? d. 217: Moving Expenses

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A TP may deduct moving expenses from income so long as his new principal place of business is more than 50 miles farther from his former residence than was his former principal place of business. Moving expenses do not include meals and are above the line deductions, so they are not subject to the rule that the expenses must exceed 2% of AGI. Rev. Rul. 99-7: Says that commuting costs are generally nondeductible except in the following circumstances: (a) if the work location is temporary and is located outside the metropolitan area in which TP normally lives and works (b) if the work location is temporary and TP has one or more regular work locations away from her residence in the same trade or business, or (c) if TPs residence is her PPOB and the work location is in the same trade or business. E. Clothing Expenses 1. Pevsner v. Commissioner Facts: TP worked at a highly fashionable and highly priced womens apparel store. She was expected to wear her employers clothes in to work. She argued that she should be allowed to deduct the cost of buying her employers clothes because they were ordinary and necessary expenses incurred in carrying on her trade and business, and therefore, deductible under 162(a). Test: Clothing is deductible under 162 if it is: (1) required as a condition of employment, (2) not adaptable to general use as ordinary clothing, and (3) is not so worn. Holding: Court held that TP was not entitled to a deduction because TP did not satisfy (2). Although TP said that she never wore the clothes because they did not fit her lifestyle, the court said that the test is objective because to employ a subjective test would be impractical. Since it concluded that the clothes were capable of being used on an everyday basis, the court denied TP a deduction. F. Legal Expenses 1. 162(a): TP is allowed to deduct all ordinary and necessary expenses that are paid or incurred during the taxable year in carrying on his trade or business. 2. 212: In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year (1) for the production or collection of income; or (2) for the management, conservation or maintenance of property held for the production of income. Differences between 162 and 212: 162 applies to a TPs trade or business and is an above-the-line deduction (i.e. not subject to 2% rule). 212 applies to a TPs

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investment/profit-seeking activities and is below-the-line (i.e. is subject to the 2% rule). 3. United States v. Gilmore Facts: TP divorced his wife and wanted to deduct his legal expenses incurred in defending his ownership interest in three corporations he owned. He sought the deduction under 212 claiming that the expenses were related to the conservation of property held for the production of income (i.e. that the corporations provided for his livelihood, and the attorneys fees were spent to protect those assets). Court: The Court and the IRS said that the attorneys fees were personal expenses and not expenses related to preservation of property. Court said that the origin of the claim is what is dispositive. Since the claim arose out of a personal activity (i.e. the divorce) and not a profit-seeking activity, the deduction should be denied. G. Education Expenses 1. Reg. 1.162-5: Education expenses must be business-related and must either: (a) be used to maintain or improve skills required by TPs employment or other trade or business, or (b) meet the requirements imposed as a condition of retaining his employment, status, or rate of compensation. In addition, the education expenses may not be used to: (a) meet minimum education requirements of TPs employment or other trade or business, or (b) may not be part of a program of study qualifying TP for a new trade or business. 2. Carroll v. Commissioner Facts: TP was employed as a detective for the City of Chicago. TP decided that he wanted to go to law school, and in order to prepare for law school, he enrolled in college to study philosophy. He sought to deduct the cost of his tuition under 162 as expenses relative to improving his job skills as a detective. Holding: 7th Circuit denied TP a deduction, stating that his education expenses were unrelated to his job. Had he taken criminal justice courses, he probably would have been allowed to deduct these expenses, but philosophy is too unrelated to being a detective. 3. More Examples a. Tax attorney attends NYU tax institute. Deduction? Yes because it is used to improve TPs skills in his trade/business. b. Teacher takes a course to keep her certification. Deduction? Yes because it is not taken to meet minimum requirements; it is retention of a job. c. IRS agent goes to law school. Deduction? No because new trade or business.

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d. Tax lawyer goes back to get her L.L.M. in tax. Deduction? Cts are split, but Yes because it is not new trade or business and is in furtherance of his trade/business. Meredith case: Financial planner that went back and got bachelors degree...qualified him for a new business. Ohio atty takes California bar: no deduction- being a CA lawyer is different that being a OH lawyer. MBA expenses: courts are split...depends on he specific facts of the case are, and depending on what the TPs existing job was and what qualification they had prior to obtaining the MBA. Hypo: 30k cost to the student to go to law school. They end up in the 33% tax bracket for 40 years. V. TIMING OF BUSINESS AND INVESTMENT DEDUCTIONS

A. Background to Capitalization 1. Capital Expenses v. Current Expenses a. Capital expenses are business expenses that cannot be deducted in the current year because they are used to buy assets that will generate income beyond the current year. Instead, capital expenses are capitalized; i.e. put into basis. Eventually, all capital expenses are deducted. (i) For a wasting asset, the expenses are either deducted annually via depreciation (applies only to tangible assets) or through amortization (applies to intangible assets). Whatever has not been deducted is recovered upon the sale of the asset. (ii) For a non-wasting asset, the expense is not subject to depreciation or amortization but is deducted at the time of sale. Depreciation is only used if the asset by its nature will decrease in value. Thus, a car is subject to depreciation. However, land is not because it does not wear out over time. (iii) Difference between a wasting and non-wasting asset: whether or not the asset holds its value throughout the year. If it does hold its value, it is a non-wasting asset; if it does not, then it is a wasting asset. b. Current Expenses are expenses that are used to buy assets that have no useful life at the end of the year. As a result, they are deductible in the current year. An example of a current expense is gas because its asset does not have a useful life for more than a year. c. Some Examples

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(i)

(ii)

(iii)

(iv)

(v) (vi)

TP buys land on 1/1 for $100k, and on 12/31 the land is still worth $100k. Can TP deduct $100k in 2003? No because the land is a non-wasting asset and so is a capital expenditure. TP may deduct the cost of the land upon selling it. Business pays $3k/year in rent. Can TP deduct $3k in 2003? Yes because it is a current expense. It does not produce an asset that retains 100% of its value at the end of the year. In this case, its value at the end of the year is $0, so TP is allowed to deduct the cost as a current expense. Buy an apartment building for $100k. Declines in value $3k/year. Can TP deduct $3k in 2003? Yes. TP can deduct the $3k in 2003 because the building is a wasting asset. It is a long-term asset that retains part of its value during the year. Thus, TP is allowed a $3k deduction. Same facts as in (iii). In 2004, TP sells the building for $100k. TPs amount realized is $100k, but its basis has been adjusted to $97k to take into account depreciation. Thus, amount of gain realized at the time of the sale is $3k. Copyright lasts 33 years. Declines $3k/year. This is an intangible asset so TP is allowed to amortize the cost. Therefore, TP is entitled to deduct $3k in 2003, but his basis in the property is reduced by $3k. Same facts as in (v). After one year, TP sells the copyright for $100k. TP realizes $100k, has a basis of $97k, and therefore, realizes a gain of $3k.

d. Summary of Rules Current Expense: TP is allowed to deduct the full amount of the deduction in the year the expense is incurred. Capital Expenses: For a non-wasting asset, TP is not allowed to amortize or depreciate the asset. Instead, TP is allowed to deduct the cost of the asset in the year of sale. For wasting assets, TP is allowed to take a deduction in the current year in the amount of (TPs basis)/(Expected Life of the Asset). For tangible assets, this is the amount depreciated; for intangible assets, this is the amount amortized. TP recovers the remainder of his basis in the year of sale. 2. Encyclopedia Britannica v. Commissioner Facts: Encyclopaedia Britannica (EB) hired a third party to write a dictionary on its behalf. TP and Tax Court: EB argued that it was paying for the third partys services and not for the asset, itself. Therefore, it said that the amount paid to the third party was a current expense, as it was an ordinary and necessary cost incurred in its trade/business under 162, and therefore, TP said it should be deductible in the current year. Tax Court agreed that TP was paying for the third partys services and not for an asset. It said that TP was the dominating force behind the dictionary; EB was the owner of the asset at all phases during the assets production, and the third party was merely assisting EB in its production.

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IRS and 7th Circuit: IRS argued that payment to the third party was for the asset produced by the third party and not for his services. It argued that the dictionary would produce income beyond the current year, and therefore, it was a capital expense that could not fully be deducted in the current year. Economic Result: Avoid capitalization by producing books in-house. Faura & Snyder: These cases said that authors and publishers were allowed to deduct the cost of writing books as current expenses. Thus, 7th Circuit had to reconcile those cases with this one. 3. 263(A)(b)(1) Closes the loophole created by Encyclopedia by requiring TPs to capitalize in-house expenditures. Exceptions to this rule are if TPs gross receipts are less than $10 million; if TP is an individual author; if the expenses are related to marketing or advertising. 4. INDOPCO Requires that TP capitalize legal and investment banker fees incident to a merger because the merger produces long-term benefits to the corporation. Court rejected the approach that said that a deduction is permitted if the expense does not create a separate asset. Tax Stories: Says that the problem with INDOPCO is that the Court did not explain when capitalization is required. It said that an incidental future benefit is not enough but did not provide a bright-line rule. B. Repair or Maintenance v. Replacement or Improvement 1. Rules a. Repair or Maintenance Expenses: Expenses that are used to keep property in efficient operating condition and which do not add value to the property or prolong its life. These expenses are deductible in the current year. b. Replacement or Improvement Expenses: Expenses that prolong the life of the property, increase the value of the property, or make it adaptable to different use. These expenses must be capitalized. 2. Midland Empire v. Commissioner Facts: TP was a meat-packing company and was located near an oil refinery. Water had been seeping into their plant for many years, but TP never took any steps to correct this problem. During the year in question, oil from the neighboring refinery began to seep into the factory. The health inspector told TP that it had to remove the oil, or else it would shut the plant down. TP spent money oil-proofing the basement

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of its plant and argued that the cost of oil-proofing was a maintenance expense, and therefore, was deductible in the current year. IRS: Argued that the oil-proofing was an improvement to the property, and therefore, the expense should be capitalized. In addition, the IRS argued that the expense should not be deducted under 162(a) because oil-proofing is an extraordinary expense. 162(a) only covers ordinary expenses. Court: Court held that the costs of oil-proofing did not add value to the basement or to the property as a whole, and the costs were made for the purpose of allowing the TP to continue to use the property for its current purpose. Although the Court said that oil-proofing is not ordinary in the sense that it is not a common expense, it is a common means of dealing with the problem. Therefore, they allowed TP to deduct the cost of the oil-proofing. mt. morris- capitalize drainage system hotel sulgrave- capitalize sprinkler system Making earthquake-proof: armt for deduction 3. Advertising Question: Should advertising expenses be treated as current expenses or as capital expenses? (e.g. should the law treat advertisements that are intended to build up the name brand of the company and have an effect lasting more than a year differently than advertising expenses promoting a sale that lasts only a week?) Answer: Rev. Rul. 92-60 says that INDOPCO does not apply to advertising (i.e. you dont have to capitalize advertising expenses even if the expenses have an effect lasting over one year). Economic Effect: Companies will spend more money on advertising rather than on other equipment if they are allowed to deduct the cost as current expenses. Congressional Intervention: Congress remedied this effect by only allowing companies to deduct 80% of advertising costs. ( C. Goodwill 1. Welch v. Helvering Facts: Petitioner was Secretary of the Welch Co., which filed for bankruptcy. TP repaid the debts of Welch even though the debts became extinguished when Welch filed for bankruptcy. He did this both out of a moral obligation and because he wanted to reestablish a good working relationship with Welchs unpaid creditors whom he would be working with in his new job. TP sought to deduct the amount of money that he repaid on behalf of Welch. Holding: Court denied the deduction for three reasons: (1) the payment was a personal expense rather than a business expense in that it was intended to enhance his

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reputation (2) the expense is too bizarre and thus, not an ordinary expense, and (3) the expense is a capital expense and not a current expense. The theory behind labeling this payment as a capital expense is the same theory that was used in INDOPCO and Encyclopaedia Brittanica: that the payments provided the TP with a benefit that extended beyond the current year (i.e. in the form of goodwill) and thus, must be capitalized. 2. 197 Prior to the enactment of 197, the law would have added TPs repayment of Welchs debt to the basis of his goodwill. However, since goodwill has a useful life, it could not be recovered annually through amortization deductions. Instead, the payment would be added to his basis and recovered only upon sale of the asset. In response, Congress adopted 197 which provides that any goodwill acquired by a TP may be amortized over 15 years. (???Welch no amortization for selfcreated goodwill) D. Ordinary and Necessary Expenses 1. Extraordinary Behavior a. Gilliam Facts: While traveling on business, TP went bezerk on a plane and hit a passenger and a crew member. He sought to deduct both the settlement payments made to the injured parties and the legal fees he incurred as a result of defending the charges against him, claiming that they were ordinary and necessary expenses under 162. He claimed that because the expenses arose out of a business trip per 162, they were deductible because they were costs associated with the trip. Holding: Court denied TP the deduction claiming that the expenses were not ordinary/common in the TPs trade or business.. It is not common for a person traveling on business to have to defend against charges incurred because of his behavior on a plane. For the court, an expense is only deductible if it is an expense commonly incurred in the trade or business. 2. Cost of Illegal or\ Unethical Activities a. 162 Before 1970, Courts did not allow a TP to deduct as an ordinary and necessary expense any expense arising out of an activity that violated public policy. Because of uncertainty as to what activities violated public policy, Congress stepped in and enacted 162 to shed light on the subject. 162(f): Disallows a deduction for a fine or penalty paid to the government.

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 162(c)(1): Disallows deductions for illegal bribes/kickbacks paid to government employees. 162(c)(2): Disallows deductions for illegal payments to others if the law is enforced. Congress intended 162 to be all-inclusive. It said that public policy in other circumstances is not defined with enough clarity to justify the disallowance of the deduction. Thus, a deduction may not be denied on public policy grounds unless it is specifically enumerated in 162. 280E: Disallows a deduction for expenditures in connection with drug trafficking. b. Stephens Facts: TP was convicted of defrauding a company and avoided prison by making restitution payments of $1 million ($530k was the actual amount embezzled which TP paid back in cash, and $470k represented the amount of interest owed, which TP paid back by executing a note). TP argued that he should be allowed a deduction for the $530k he paid back because he already paid tax on that amount when he embezzled it and claimed it as income. IRS denied the deduction on public policy grounds saying that if TP was allowed to deduct the money, it would take the sting out of the punishment. Holding: Court said that TP can deduct the $530k. The court said that 165(c) (2) did not apply because there was no showing that it would frustrate public policy. E. Depreciation and Amortization 1. Tangible Property (Depreciation) a. Pre-ACRS For a wasting asset with a determinable useful life, TP is required to capitalize the asset and recover the cost annually through depreciation. There are three different methods of depreciation that can be used: (i) Straight-Line Depreciation: (Basis)/(Useful Life). Thus, if TP has a basis of 10k and the asset has a useful life of 10 years, $1k of depreciation is allowed every year for 10 years. (ii) Declining Balance Method: Percentage x [(Remaining Basis)/(Original Expected Life)] until depreciation under this method becomes less than straight-line depreciation; when that happens straight-line depreciation is used. Thus, if TP has a basis

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of 10k and the asset has a useful life of 10 years and the double declining balance method is used, TP is allowed to take $2k of depreciation in the first year (200% x (10k/10yrs) = $2k), $1600 of depreciation in the second year (200% x (8k/10yrs) = $1600) etc. The double declining balance method is used for the first 6 years because for all six years the amount depreciated under this method exceeds the amount that would be depreciated under straight-line. In year 7 if straight-line were used, depreciation would be $655 ($2622/4yrs remaining). Thus, because straight-line depreciation yields more depreciation than double declining balance, it is used for years 7-10 and so $655 is depreciated each year for years 7-10. (iii) Sum-of-the-Years-Digits: [Basis x (Years Left/Sum of Years)]. Thus, in the previous examples, if TP has a basis of $10k and the asset has a useful life of 10 years, then depreciation is $1,818 in the first year [10k (10yrs left/(10+9+8+1)]. In year 2, depreciation is $1,455 [ 10k x (9/55). b. ACRS Personal Property: 168 assigns arbitrary useful lives to personal property. There are six categories to which an asset can be assigned: 3 yr, 5 yr, 7 yr, 10 yr, 15 yr, or 20 yr useful life. Depreciation is calculated using double declining balance method for years 3, 5, 7, and 10. For years 15 and 20, the percentage used in 150%. Real Property: Congress assigned a useful life of 27.5 years for residential property and 39 years for commercial property. The method of depreciation used for each asset is straight-line depreciation. 2. Intangible Property Problem: TP acquires more than 1 asset (e.g. business where you require material assets and goodwill). IRS wants to allocate a greater portion of the purchase to goodwill because TP cannot amortize goodwill. TP wants to allocate less of the purchase to goodwill so he can amortize more. Solution - 197: In order to resolve the conflict between TPs and the IRS, Congress adopted 197, which allows TPs to amortize goodwill over 15 years. F. Tax Shelters 1. Ketsch a. Facts: TP pays $4k in cash and borrows $4 million nonrecourse at 3.5% interest. TP uses this money to buy a $4 million 30-year deferred annuity that pays

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2.5%/year. Why does TP want to pay $140k/yr ($4 million x 3.5%) only to receive $100k/yr ($4 million x 2.5%)? He loses $40k a year from this transaction; why does he do this? Answer: Because he can deduct the $140k from income. Since he is in the 90% tax bracket at the time, this translates into savings of $126k in income that would be lost from the income tax. Therefore, if he pays $40k to save $126k in taxes, he has a net gain of $86k. TP: argues that he should be allowed the deduction because it meets the form of 163. IRS and Court: says that the transaction was a sham; there was no economic substance to it, no economic gain possible, and the indebtedness was not real because the loan was nonrecourse. Therefore, deny the deduction 2. Estate of Franklin a. Facts: Partnership of 8 doctors buys a motel for $1.2 million and lease the hotel back to the sellers. The doctors pay $75k in cash as prepaid interest on the purchase. The sellers agree to sign a 10 year nonrecourse note to pay the doctors $975k in Year 10. This transaction results in $9k rent to the doctors, which is deductible by the sellers and included in income for the doctors. However, the doctors are permitted to deduct the corresponding $9k in interest, so the transaction is a wash. Why did the doctors make the deal? Because, as owners, they can depreciate their basis in the building which is a good deal for the doctors because they are in the 70% tax bracket. By paying $1.2 million, they get to depreciate the value of the building over 39 years which translates into depreciate in the amount of $31k/year. Why do the sellers make the deal? Because they receive $75k in cash up front and can default on the note because it is nonrecourse. b. Holding: Court disallows the deduction because it says that the transaction is a sham. 3. Review Crane: Where FMV of the property > than the nonrecourse debt at the time of acquisition, the debt is included in a TPs depreciable basis b/c the TP has equity in the property, and thus, is motivated to pay off the debt. Tufts: Where the nonrecourse debt > FMV at the time of the sale, include the amount of the debt in the amount realized because the assumption is that the TP will not repay the debt.

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Franklin: Where nonrecourse debt > FMV at the time of the purchase, do not include the debt in depreciable basis because the TP does not have any equity in the property, and thus, does not have the motivation to repay the debt. 4. Legislative Response a. 469: PALS: (a)(1) cannot use PAL to offset salary or investment income only passive income. (b) PALs can be carried forward. (g) PALs are allowed on the sale of TPs entire interest. 469 only applies to passive losses. Hypo #1: Attorney invests in a restaurant (passive investment). The restaurant loses $10k in 2002 and $10k in 2003. TP sells the restaurant in 2004. TP is not allowed to deduct $10 in 2002 or 2003 because of (a)(1), but can deduct $20k in 2004 when it is sold under (g). Hypo #2: Attorney also owns a bakery which is also a passive investment. In 2002 the restaurant loses $10k and the bakery produces $5k of income. (a)(1) allows TP to use $5k of the loss from the restaurant to offset the $5k of income from the bakery. 2003 TP sells the bakery. 2004 restaurant produces $3k of income. $3k of the loss can be carried forward under (b) and used to offset the $3k of income. 2005 TP sells the restaurant. TP can deduct the remaining $2k at this time. Hypo #3: On 1/1/99, TP borrows $100k recourse to borrow stock. In 1999 she pays $10k in interest and receives $15k in dividends. In 2000 she pays $10k in interest and receives $0 in dividends. In 2001 TP pays $10k in interest and receives $15k in dividends. How much is TP allowed to deduct in 1999, 2000, and 2001? In 1999, TP can deduct $10k. In 2000 he cant deduct anything. In 2001, he can deduct $15k. So total interest paid is $30k, total income earned is $30k, and total deductions are $25k.

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