Federal Income Tax Outline Professor Doran Fall 2006

ABBREVIATION ! F"V! fair market value NO#! net operating loss $%E! Highly compensated employee RAF"V! readily ascertainable fair market value EIT%! Earned Income Tax Credit PA! Passive Activity A"T! Alternative Minimum Tax %&! capital gains %#! capital losses I INTRO !"#$% A' $istorical Bac()round of IR% " &irst the '( started using excise taxes on li)uor* carriages* slaves* and real property + ,efferson repealed taxes- tariffs became the federal revenue source $ Income tax re#administered as flat tax in "./0 !a Constitutional challenge based on mandate that direct taxes on states must be apportioned to states based on population !i 1o one kno2s exactly 2hat a 3direct tax4 is !ii It is agreed that a head tax5flat amount on everyone5is a direct tax !iii Problem is that if you apportion income tax on the basis of population* people in different states 2ould pay different rates- people in poorer states 2ould pay a higher tax rate B' Taxa*le Income " 6%$!a 7 for individuals 2ho don8t itemi9e their deductions* it is ad:usted income minus deductions + 6%$!b 7 for individuals 2ho do itemi9e* it is gross income minus deductions allo2ed; $ 6%+!a 7 ad:usted gross income is gross income minus deductions 0 The rule that applies to the total amount of income of the top rate in your bracket along 2ith all of the lo2er rates; %' Tax+a,ers! %ate)ories " Married individuals filing :ointly + Heads of Household $ (ingle Individuals 0 Married individuals filing separately < #eisure Time and Income Taxation " the extra money you make above normal hours 2ill be taxed at the highest rate in your bracket5this is the most relevant number 2hen thinking about responses to incentives of 2ork v; leisure time; E "arria)e and Income Taxation! C=ME >AC? T= THI( <'@I1A I1C=ME ATT@I>'TI=1 " Polic,! (hould the government be encouraging people to marry or notB If so* should they do it through the tax system* in a 2ays that encourages some people to marry and not others* or encourages the secondary earner not to 2orkB !a >ush Tax Cuts did provide some relief to the marriage penalty but only at the expense of increasing the marriage bonusCthe penalty on the high 2age earner staying single;

!b It is impossible for the federal tax code to be neutral on marriage encouragement 2ith the progressive rates structure and commitment to treating all married couples the same regardless of each spouse8s contribution F' Pa,in) Taxes -' Procedure !a TP files a return 2ith I@( service center !b Potential audit !c Potential appeal to I@( appeals office !d If TP fails* can litigate in !i '( Tax Court7 appealable to '( Court of Appeals If you sue here* don8t have to pay first and then sue for a refund5you can refuse to pay until it rules 1o right to a :ury trial here Article I :udge Dill follo2 the la2 of the Circuit 2here TP lives !ii '( &ederal <istrict Court7 Appealable to '( Court of Appeals Article III court 1ormal civil procedure !iii '( Court of &ederal Claims7 Appealable to &ederal Circuit Article I court !e If TP fails at that level* can appeal to (C=T'( but only on certiorari + Pa,in)! you should .a' /nder an A"ORA# 0ie1 !i Dorst thing that can happen for not paying is a EFG if you don8t commit a crime !ii =nly a +G audit rate so even if the government al2ays 2on !2hich it doesn8t there is little incentive to pay taxes !iii Exam+le! TP o2es H"II in tax; Expected cost is H"II; If you don8t pay* get caught* and get the maximum penalty* you 2ill o2e H"EF; >ut there is only a +G chance you 2ill have to pay that* so expected cost of not paying your taxes is only H$;FI; II' IN%O"E A' Definitions -' Income !a Haig-Simons definition of income! 2hat you spend plus 2hat you save in a given time period !i Dould also include imputed income !parent raising child instead of paying for childcare ; !ii De don8t use this definition for tax purposes !b Economic! Consumption plus savings !see consumption tax section !c There is no crisp definition of income for tax purposes !d (C=T'( initial definition !later abandoned 7 gain derived from labor* capital* or both; !e %ommissioner 02 &lens3a1 &lass !EI !i &ACT(7 t2o cases involving receipt of punitive damages- both TPs excluded the punitive damages they received since they 2eren8t derived

from income or capital* and that 2as the going definition of income at the time; !ii H=J<I1A7 punitive damages are undeniably accessions to 2ealth over 2hich the TPs have complete dominion* so they are income* and the definition of 3gain derived from labor or capital8 is abandoned !iii (ince this case* there is a presumption that any increase in wealth is income 2' Amount of )ain or loss = amount realized minus adjusted basis 4-00-.a' $ Amount reali5ed 6 HH received plus &MK of property 4-00-.*' 0 Ad7usted *asis6 basis as ad:usted by 6"I"% 4-0--.a' !a 4-0-6.a'.2'7 ad:ustment is 2hat you took or could have taken for depreciation; !b 4-0-6 prevents TP from using basis t2ice to get extra deductions; <epreciation deductions are :ust an advanced recovery of basis; F Basis of +ro+ert,L cost of property 4-0-2 !a %arr,o0er8su*stitute *asis! ad:usted basis in the hands of the transferee is the same as ad:usted basis in the hands of the transferor; 4-0-9.a' !b +ecial rule! &or determining J=((* the basis is the &MK at the time of the gift if it 2as less than the transferor8s ad:usted basis- &MK is only used 2hen the result 2ill be a loss !c If neither of the above calculation methods 32ork4 then there is no gain or loss for tax purposes B' Excluda*le8Non:Income %om+ensation .Em+lo,er In:;ind %om+ensation' " Bena)lia 02 %ommissioner- $% >TA .$. !0+ !a &ACT(7 TP 2as a manager of hotels in Ha2aii- re)uired as part of :ob that he and his 2ife live and take meals at on of them; I@( said TP had an undervalue of 6E*.0F for each year he8d 2orked there* for the &MK a guest 2ould pay to stay and eat there for a year; !b H=J<I1A7 Jiving and eating there 2as not income at all bCc !" parties didn8t intend for room and board to be compensation !+ room and board 2ere provided for convenience of ER !i it 2as a condition of employment and necessary to E@; !ii @oom and board* unlike stock* personal and non#transferable !iii @oom and board hard to value here bCc certainly not 2orth to EECTP 2hat it 2ould be 2orth to a guest; !c <I((E1T7 room and board 2as not value#less !d <=@A17 problem 2ith the holding is that the burden of the 3break4 to TP goes to all the other taxpayers in the country; Also the hotel is benefiting from the tax break5they can probably offer him less cash than a cash only :ob7 a cash only :ob 2ould cause him to be taxed on 2hat he spent on room and board and here he is not; + IR% 4--<! if meals and lodging are provided for the convenience of the E@ and the EE is told they have to live and take their meals on the E@8s premises* then meals and lodging 2ill not be included as EE8s income; !a Codifies the >enaglia holding !b 1o intent re)uirement as there 2as in >enaglia* though $ IR% 4-0=! applies to 3ministers of the gospel- similar to 6""/ but does not re)uire convenience of E@ and a cash rental allo2ance may be excluded from minister8s gross income as 2ell as in#kind lodging on E@8s premises; !a >eneficiaries7 ministers of the gospel* congregations 2ho don8t have to pay them as much

!b @umblings of constitutional challenges based on establishment clause 4->2.a'.-' No additional cost ser0ices! can8t cost the E@ anything* including lost revenue* to provide to EE !a under 6"$+!: must not be concentrated among highly compensated EEs 2ithout also being given to a group of EEs that does not discriminate on the basis of highly#paid !b 6"$+!b says it must be something that the E@ offers for sale to customers in the ordinary course of business of the E@ in 2hich the EE provides services !c Aenerally applies to spouse and dependent children of EE under 6"$+!h !+ !A and retired or disabled EEs or the surviving spouse of an EE under 6"$+!h !" !d + or more E@s are allo2ed to make a reciprocal agreement for the provision of tax#free no#additional#cost services to their EEs* if the agreement is in 2riting and neither 2ill incur substantial additional cost in providing the services; 6"$+!i ; 4->2.c' ?ualified EE Discount7 EEs can get a reasonable discount on property or services offered for sale to customers by E@ 2ho employs the EE getting the discount !a &oods! Ceiling is the profit percentage7 !aggregate sales price minus the aggregate cost Caggregate sales price; 6"$+!c !" !A !b er0ices! discount cannot exceed +IG of the price at 2hich the service is offered for customers; 6"$+!c !" !> ; !c under 6"$+!: !" must not be concentrated among highly compensated EEs 2ithout also being given to a group of EEs that does not discriminate on the basis of highly#paid !d If the discount is greater than the ceiling* the amount the EE saves over the amount they 2ould save 2ith the )ualified discount is included in their taxable income; P; %+ EME; !e Aenerally applies to spouse and dependent children of EE under 6"$+!h !+ !A and retired or disabled EEs or the surviving spouse of an EE under 6"$+!h !" ; !f No exclusion for discounts on property held for investment or real property; 6"$+!c !0 ; 4->2.d' @or(in) %ondition Frin)e! if it is something that the EE could deduct as a business deduction if she bought it herself !i;e; ordinary and necessary business expense * the E@ can provide it to her 2ithout it being includable in her income; !a (ome2hat more valuable this 2ay as an exclusion than if EE deducts it herself !i Certain EE business expenses deductible only of TP itemi9es 6%$- 2ith 2orking condition fringe that never comes in to the picture !ii EE business expenses generally deductible only to the extent they exceed +G of TPAs AAI; 6%E; 4->2.e' De "inimis Frin)e! coffee and doughnuts* personal use of copy machine; Costs government HE> a year but alternative is cra9y; !a =ccasional dinners paid for by E@ and brought to the office* or even an occasional cash allo2ance for dinner* to extend 2orking hours probably count under this section; P; %$ EME !b Membership in a private country club or gym does not count; @eg; 6";"$+#%!e !+ !i Ho2ever if an E@ builds an athletic facility on its premises* EEs do not have to include the value of use of those facilities in their income 2here the use of the facility is primarily for the use of EEs and their spouses and dependent family memebrs; 6"$+!: !0 ; !c Having a cafeteria 2here the meals are cheaper than normal !:ust above cost for E@ counts for an exclusion; 6"$+!e !+ ;

4->2.f' ?ualified Trans+ortation Frin)e Exclusion if E@ provides or reimburses for a transit pass* transportation in a commuter high2ay vehicle !6"$+!f !F !> * or parking 2Cin a monetary limit see 6 for limit; !a 1o nondiscrimination re)uirement5can be offered only to HCEs and still be excludable from their taxable income !b If you are given a choice bC2 cash and parking* you get an exclusion if you choose parking* but not if you choose cash; (omeho2 meant to be an environmental initiative but utili9ation of E@ parking 2ent 2ay up after this 2as allo2ed; C Im+uted Income !%$ " =2ner#=ccupied Housing7 rental value of o2ner#occupied house is imputed economic income to o2ner 2ho lives in her home5you don8t have to pay rent bCc you live in your o2n house; @ight to live in or allo2 someone else to do so is part of the value* as is appreciation; (o there is no good policy reason 2hy 2e don8t allo2 deduction on cost of rent* but of course 2e also shouldn8t start taxing imputed value of o2ner#occupied housing; + (ervices 2Cin Household7 (houldn8t start taxing them* but the failure to tax them does cause distortions D' &ifts " 4-02.a'! gross income does not include property ac)uired by gift* be)uest* devise* or inheritance- i;e; gifts are excluded from income for tax purposes; !a This applies only to the value of the gift at the time of its receipt !the principle of the gift or be)uest * not income 2hich the gift subse)uently generates; 6"I+!b !+ ; !b E;g; 2ith a giftCbe)uest of a trust* if both the corpus and income 2ere exempt from tax under 6"I+!a * the exclusion 2ould be greater 2hen divided interests 2ere created than 2hen the entire property 2as given to one person 2' @3at constitutes a )ift for tax +ur+osesB !a %ommissioner 02 Du*erstein !EF !i &ACT(7 TP got a Cadillac from a business contact as a thank#you for a good lead- TP did not 2ant it and tried to refuse* but the business contact gave it to him any2ay !even though he already had a car ; Then he didn8t include the value of the Cadillac as income; The Commissioner asserted deficiency for the car8s value against him; !ii H=J<I1A7 Car 2as income- it 2as at bottom compensation for <uberstein8s part services; !b tanton 02 /nited tates !E%* part of <uberstein !i &ACT(7 Dhen TP retired from 2orking for a church to go into business for himself* the church he 2orked for gave him H+I? to be paid in monthly installments 3in appreciation for the services rendered4 by him; The members of the board described it as a giftCgratuity based on his great personality and excellent 2ork* but there 2as also evidence of ill#feeling bC2 (tanton and some of the board members; He had on enforceable claim to a pension or retirement benefits; !ii H=J<I1A7 The (C=T'( remands to the district court again; =n remand* the trial court again holds that the payment 2as a gift* based on the standard of detached and disinterested and based on generosity; !c Eventually (C=T'( says that 2hether a payment is a gift is an issue for the trial court* determining donors intent* and 2ill be upheld unless clearly erroneous;

>' Basis in )ifts !a Rules !same as on p; E of outline !i %arr,o0er8su*stitute *asis! ad:usted basis in the hands of the transferee is the same as ad:usted basis in the hands of the transferor; 4-0-9.a' !ii +ecial rule! &or determining J=((* the basis is the &MK at the time of the gift if it 2as less than the transferor8s ad:usted basis- &MK is only used 2hen the result 2ill be a loss !iii If neither of the above calculation methods 32ork4 then there is no gain or loss for tax purposes !iv If property is transferred at death by be)uest* inheritance* etc* the basis in the hands of the transferee is 3stepped up4 to the &MK at the time of death; 6"I"0!a ; !b Taft 02 Bo1ers !/% !i &ACT(7 A bought "II shares of stock for H"? 2hich he held until "/+$ 2hen the &MK had become H+?; Then he gave them to > 2ho sold them during "/+$ for HF?; > says that she only o2es tax on the appreciation during her o2nership of the stock !H$? but the I@( says she o2es tax on H0?* the total appreciate since A bought it; !ii H=J<I1A7 Congress does have the po2er to re)uire a succeeding o2ner to assume the place of the donor in terms of taxation5so the basis of the inter vivos gift is the same in the hands of the donee as it 2as in the donor; > o2es taxes on the entire H0? increase in value; The stock represented only a single investment of capital* that made by the donor; C' c3olars3i+sD Pri5esD and A1ards !a (cholarships covering tuition and re)uired fees* books* supplies* and e)uipment at non#profit schools are excluded from gross income; 6""E; !i Ho2ever* scholarships to go to2ard room and board are includable in gross income; !ii Exclusion does not apply to scholarships conditioned on the performance of teaching* research* or other services; 6""E!c ; E Reco0er, of %a+ital !"IF " Timing of 2hen TP recovers basis determines 2hen TP pays tax; + Exam+le! N buys "I acres of land* all the same* for H"III; (ells a fe2 years later for H"FII; Aain is HFII* that is the taxable income; H"III 2as :ust capital converted to different forms !cashland* then landcash ; $ Ina7a #and 02 %ommissioner !"IE !a &ACT(7 TP bought land for H%"? bordering on 2ater to be used as a fishing club; The city polluted the 2ater and TP sues and gets HFI?* H"III of 2hich 2ent to atty8s fees; I@( said H0/? 2as taxable income bCc use of land 2as for profit* it didn8t exceed the cost of the land* and the money 2as for lost profits; TP said it 2as not for lost profits bCc the re2ard didn8t exceed cost of land and only constituted recovery of capital !or that it 2as impossible to separate recovery of capital and loss of profits ; !b I@( A@A(7 The money 2as compensation for loss or present and future income and consideration for release of many meritorious causes of action 2hich represented ordinary income; Also* the N failed to allocate the sum bC2 taxable and nontaxable income* so it did not sustain its burden of sho2ing I@( error;

!c N A@A(7 The consideration 2as paid for the easement granted to the city and the conse)uent damage to N8s property rights- that it 2as an easement means it is not practical to attempt to apportion a basis to the damaged property; !d H=J<I1A7 The re2ard 2as not paid for loss of profits* it 2as for the conveyance of a right of 2ay and easements and for damages to N8s land and its property rights; The I@( is 2rong; Capital recoveries in excess of cost are taxable income* but here it is impractical to apportion basis to the parts of the property damaged; Therefore* because the payment 2as recovery of capitalCbasis* and it 2as less than N8s cost basis for the 2hole property* there is no capital income* and a basis of H"+? left on the property !H%"? minus H0/? ; !e <=@A17 appears to come do2n to timing52on8t change the ultimate gain or loss bCc 2hen TP sells the land 2hat 2ould have been counted as recovery basis 2ill be taxable gain- so all TP gained 2as deferral of 2hen he had to pay tax; F' Time Value of "one, " It is generally understood to be better to pay taxes in the future than in the present; + Oou can set aside a small amount of money in one year and thirty years later have a lot more- so it is better to pay taxes on a certain amount many years in the future than on the same amount today; $ The farther in the future you defer it* the less it is 2orth today !so you 2ant to defer for as long as possible ; 0 Formula! Present Kalue L &uture Kalue divided by Pone plus the interest rateQ to the po2er of the compounding period; !a Exam+le! in present dollars* a H+F? bill in thirty years costs only H0$FI or so; H+F?C!" R I;I% to the po2er of $I L H0$FI; pp; $I#$+ in C> and 0$/#000 in Chirelstein and "F in EME; !b Exam+le 2! H+I? in five years 2ith a "IG interest rate is +I?CP"R"IGQto the po2er of F; Present value L H"+*0".; &' Annuities and #ife Insurance! " Policy holder is often the insured* but doesn8t have to be; Insured pays a certain amount in premiums and insurance company 2ill pay death benefit to survivors if insured dies during the policy period; 2' #ife insurance !a Term Insurance! bet bC2 insured and life insurance company5:ust death benefit protection during a specified period of time; <oran likes this best; !b %as3:0alue Insurance! involves a savings element as 2ell as term insurance; !c 4-0-.a'! any amount paid out under a life insurance contract for the death of the insured is not taxed as income to the beneficiary; All death benefits are excludable; !d Insura*le Insurance ReEuirement! you can8t buy life insurance on someone 2ith 2hom you don8t have some kind of relationship- this is an attempt to restrict dead peasant insurance by E@s; $ Annuities7 pays out during the life of the individual- pays for you not dying soon enough as opposed to having died too early; <oran says a 2aste of money because of huge fees like cash value insurance; p; /I EME; !a Immediate Annuit,! starts as soon as you pay !b Deferred Annuit,! does not start until specified future time !c Tax Treatment! very favorable; There are three main tax benefits;

4=2.a'7 TP not taxed during time the money is accumulating* unlike a savings account* bonds* or stocks 2here interest and dividends are taxed as earned 2hether 2ithdra2n or reinvested; 6E+!u says that if you are a corporation and hold a deferred annuity* you DIJJ be taxed on inside build#up* unlike an individual !ii 4=2.*'! 2hen money is 2ithdra2n* some is taxable and some is return on basis5investment in the contract is the basis and that is divided by expected return !actuary comes up 2ith expected return ; Exam+le! TP invests 6FII? and actuaries say expected return is H";FM; @atio is "C$* so H" of every H$ that is 2ithdra2n is a return of basis; If the annuity is H0F?Cyr* only H$I? of that is taxable; Oou don8t ACT'AJJO get basis back at a steady rate5you get more earnings in the early years* but the tax code treats you as though you are getting a pro#rata amount each time* 2hich is a tax advantage; !d Polic, Rationales! Encourages savings so people can pay for their o2n retirement; !e Borro1in) A)ainst an Annuit,7 tax treatment much less favorable than it used to be; p; /$ EME $' Annual Accountin) " &eneral! 2e calculate income on the basis of each year* annually52hat happens to TP in each year* !a Pretty arbitrary as a convention !b Aenerally the calendar year for individuals* may vary for businesses + T3e %lar( 02 anford Broo(s Pro*lem !a %lar( 02 %ommissioner !"+" !i &ACT(7 TP8s tax preparer gave him bad advice* telling him to file separately from his 2ife; If he had filed :ointly he 2ould have saved H"/*/0" in income tax; Tax preparer paid him that amount a fe2 years later; !ii H=J<I1A7 TP is allo2ed to exclude that payment from faulty tax preparer from his income in the year it 2as paid; !b Burnet 02 anford F Broo(s !"+% !i &ACT(7 TP had net losses totaling H"E%*+E" over a period of three years in a contract 2Cgovernment; It received H"/+*FEE;F/ in a suit 2ith the govt* 2hich 2as the loss plus interest; !ii H=J<I1A7 TP had to include not only the interest but also the H"E%*+E" in income in the year they received the settlement from the govt; %lar( #O !H"/*/0" "/$+ !H"E%*+E" "/"$#"/"F RE%OVERG H"/*/0" "/$0 H"E%*+E" "/+I O/T%O"E RATIONA#E recovery @ecovery of capital excludable recovery includable Annual* not transactional* Accounting

!i

anford F Broo(s

.c' @3, t3e differenceB !i <ifference in initial expenditures7

Clark* did not and could not have deducted the loss 2hen it happened* so maybe court is trying to line up economics 2ith tax; It 2as not deducted 2hen it 2as lost* so it 2as off the tax radar* and 2hen he received it a couple years later it 2as off the radar (anford M >rook7 did take the deduction on the losses for three years; (o if it had gotten the money back tax free* it 2ould not have netted out to 9ero; Ho2ever* their income 2as 9ero in those years* so them taking the deduction didn8t change the taxes they 2ere paying- this means that the situations really 2eren8t e)uali9ed after all; !ii Dhat C='J< the court have done to solve the unfairnessB Aive individuals 2Cnegative income a payment from the government in amount you 2ould have paid in taxes if you have made the amount that you lost; >A<7 could incentive creation of paper losses to get gov8t money A==<7 might incentive people to take beneficial risks; .d' #e)islati0e Res+onses to T3e Difference !i 4-=2.c'7 NOL is tax deductions minus gross income !ii 4-=2.a'! you get a deduction for the sum of your 1=J plus your 1=J carryback !iii 4-=2.*'.-'.A'! NOL carryback is allo2ed for t2o years prior and NOL carryover is allo2ed for t2enty years in the future; !iv 4-=2.*'.2'! you do your carrybacks first* then carry for2ard !v 4-=2.*'.>'! you can 2aive carry >AC?( if you 2ant to !not carry for2ards !vi >asically* you can take unused loss and move it back and for2ard in time to eat up income; !vii 'nder the 6"E+ regime* the TP in (anford M >rooks could have carried for2ard the H"E%? loss for +I years* 2iping out the entire H"E%? settlement they received a fe2 years later; >' %laim of Ri)3t !a Nort3 American Oil %onsolidated 02 Burnet !"$" !i &ACT(7 TP and '( Aovernment are fighting over land* 2hich is generating income; In "/"%* that income held by a receiver pending dispute resolution; In "/"E TP 2ins* and "/"% income is paid to TP; I@( says that money 2as taxable to "/"E 2hen received- TP says it is taxable to "/"% 2hen earned* or "/++ 2hen the last appeal 2as decided in its favor; !Tax 2as higher in "/"E bCc of 2ar than it 2as in "/"% or "/++ !ii H=J<I1A7 TP has to be taxed on the income in "/"E; If a TP gets earnings under a claim of right* he must report them to the government even though someone else might claim he is not entitled to the money and even though he might lose it in court later; The TP here did not do that in "/"%- and he received the money in "/"E- so that8s 2hen it is taxable to him; !b /nited tates 02 #e1is !"$0 !i &ACT(7 =n "/00 return* TP reported H++? 2hich he had received as an EE8s bonus- ho2ever as a result of subse)uent litigation* it 2as decided that the bonus 2as improperly computed and he had to return H""? to his E@;

'ntil that :udgment* he had claimed and used the H++? entirely as his o2n under the good faith 3mistake4 belief that he 2as entitled to it; !ii H=J<I1A7 entire amount includable in "/00- though TP gets a deduction in "/0% 2hen he had to return half of his bonus; 'nder the claim of right doctrine* there is no exception merely because a TP is mistaken about his claim of right; !iii <=@A17 This result is even 2orse than 1orth American =il* bCc TP had to include at a high rate and deduct at a lo2 rate; There are a fe2 2ays the unfairness C='J< have been dealt 2ith; Dait to tax until after all doubts about money are resolved >A<7 could incentive TPs to manufacture disputes Probably 2ouldn8t have made a difference in Je2is bCc there 2as no cloud over the bonus in "/00 any2ay 'se hindsight* and compute the tax 2hen HH received but if it turns out that it 2asn8t income* allo2 a redo of the return for that year This is 2hat Je2is had 2anted >A<7 results in uncertainty* leaves returns open forever* inefficient @eport income based on ho2 strong the claim is to the income !FIG you get to keep it* report FIG of it* pay more as doubts become resolved ; >A<7 un2orkable; !c #e)islati0e Res+onse! 4->C-! if the amount 2as included in income in prior years bCc it appeared that TP had an unrestricted right to it !claim of right then TP gets a deduction on current year for that amount if it turns out TP did not have a right to that amount; !i Dhat 2ill happen is either7 TP 2ill compute the tax taking into account the deduction TP 2ill get in current year Take the amount of tax TP 2ould not have paid in the prior year if TP had not included the amount then* and take that as a deduction in the current year !ii >rings you back up to HI if you are a loser under claim of right; (ee p; +0 of notes for example tables; !iii <oes not take a2ay any 2indfall that might come to TP under claim of right; C' Tax Benefit Rule !a 4---.a'! Exclusionary rule7 gross income 2on8t include income from recovering an amount TP deducted in a previous year as long as the deduction did TP no benefit in year it 2as deducted; !b 4---.c'! An increase in a net operating loss !1=J carryover that is still around is treated as reducing tax for the purpose of 6"""!a ;
OEA@ S Case I Case II Case III Case IK Amount of Joss !HF? !HF? !HF? !HF? Aross Income H+F? I H$? H+F? Taxable Income H+I? !HF? !H+? H+I?

OEA@ O !year 2hen all 1=Js expire unused

Case I Case II Case III Case IK

@ecovery HF? HF? HF? H"?

=utcome under 6""" Include HF? in O HF? excluded in year O H$? included in year O H"? included in year O

!c 4--- is chiseling a2ay at the idea of an annual accounting period !i TP8s perspective7 can be helpful* but if rule of inclusion comes into play as in Case T there is no relief from change in tax rates; !d Income A0era)in)! 1=T done no2- idea is that TP could average for a certain number of years to protect against s2ings in income; Made more sense 2hen top marginal rates 2ere very high; I' $ealt3 Insurance " 4-06.a'7 EE8s gross income doesn8t include E@#provided coverage of accident or health insurance; (ection also covers retired former EEs* and spouses and dependants of EEs* but not unmarried couples 2ho aren8t dependants; E@#provided domestic partnerCsame sex couple coverage creates extra federal taxable income to EE; !a E@ provided doesn8t mean E@ has to pay the 2hole bill* but E@#provided portion 2ill be excluded from EEs income !b Policy originated from 2age controls during DD nII* 2hen E@s had to compete for EEs using fringe benefits- by "/F0 it 2as common not to consider health benefits income* so Congress 2ent along 2ith it; + 4-09.*'! benefits out of an E@#provided health or accident plan also not includable in EECbeneficiary8s taxable income; (eems like a huge incentive to consume medical services* bCc of the tax subsidy at both ends; $ (ome think repealing these rules 2ould increase the number of insured people !2ith other reforms* presumably , Personal In7ur, Reim*ursement !"0" " 4-0C.a'.2'! any damages received on account of personal in:uryCsickness are excludable* from 2orkers compensation or settlement of a suit* 2hether a lump sum or periodic* except punitive damages or lost profits; !a 3Jump sum or periodic4 language means that NCTP can choose an annuity- if NCTP chooses an annuity* not only are the damages untaxed* the interest is as 2ell !i Aood deal for N5creates an incentive to structure settlements to provide deferred periodic payments !ii >ad for U 2ho 2ill be taxed on interest earned on money put aside for the periodic payments to N* and 2ill have to invest a larger sum in order to stretch the payments out; !b Aenerally U funds such payments through an insurance product !i 1either N nor U thus pays taxes !ii N gets more money in the long run bCc not taxed on interest !i;e; if N took a lump sum and invested it* the interest 2ould be taxable income* but payments coming out of life insurance at 2hatever rate N 2ants are not taxable to N ; (ee p; """ EME Problem E+; !c A2ards for lost DAAE( are excludable* :ust not lost profits; !d TP excluding the income can be someone other than the person 2ho suffered the in:ury or sickness !e;g; spouse* dependent ; !e The only case in 2hich punitive damages are excludable are 2hen a state =1JO allo2s recovery of punitive damages;

!f Rationale! Exclusion serves as a proxy for a system of depreciating human capital; =ther args for and against taxation of certain a2ards; !i "edical Ex+enses! Places the in:ured person in the same financial position they 2ould be in 2ithout the in:ury- fairness dictates she should not pay more than others in taxes !ii #ost @a)es! replaces funds that 2ould have been taxed other2ise- fairness dictates that she should be taxed on income she 2ould have been taxed on but for the accident; >ut they are excluded; !iii Puniti0e Dama)es! These are complete 2indfall to the recipient so should be taxed !the only argument against taxation is that not taxing these gains might encourage more people 2ho are actually 2ronged to sue to recover + "ur+3, 02 IR !a &ACT(7 TP 2as a 2histleblo2er 2ho eventually got HEI? in damages from E@ for emotional distress 2Cphysical symptoms- H0F? for emotional distress and H+F? for in:ury to reputation- nothing a2arded specifically for physical in:uries; TP paid tax on the a2ard then sued for a refund; !b TP THE=@IE(7 !" should be excluded under 6"I0!a !+ ; !+ 6"I0!a !+ is unconstitutional; !c H=J<I1A7 6"I0!a !+ is unconstitutional* because TP 2ould not be able to exclude under it* though none of the money TP received 2as a return on lost 2ages or earnings* it 2as a return of human capital :ust like the physical in:uries excludable under 6"I0!a !+ ; Emotional distress e cludable if it is the by!roduct of other !hysical injury; !d <=@A17 this opinion 2as bull; The only good part 2as that Ainsburg8s argument 2as valid of policy grounds in critici9ing the distinction bC2 physical and non#physical in:uries; >ut Congress8 po2er to tax comes from Article I* and the government does tax a lot of things that are not income as long as they are not direct taxes; ;' Inde*tedness " Interest! includable income for the creditor- usually deductible for the debtor paying it unless the debt is for personal consumption; + Princi+le! 2e don8t tax borro2ed money as income* but there is no specific provision in the I@( excluding it from income; The rationale is that 2hen you borro2 it* you are the same time take on a contractual obligation to repay it* so there is no net accession to 2ealth; This is another little dig at annual accounting* note; $ Formula for amorti5ation of loan! see /I#/" EME 0 Disc3ar)e of Inde*tedness means forgivenessCrelease of indebtedness !a / 02 ;ir*, #um*er !"0E !i &ACT(7 TP issued bonds !debts in "/+$ for H"+M* then bought back "C"+ of the bonds for H.%+?; !ii H=J<I1A7 the H"$.? difference I( taxable income; Those 2ho buy the bonds are loaning TP money- 2hen TP paid off the loan by buying back the bond* it 2as discharging indebtedness* in this case for less than the amount of the loan; !b Deidric3 02 %ommissioner !"F/ !i &ACT(7 TP 2anted to give a gift of stock to kids on the condition that the kids 2ould pay the gift tax; !ii H=J<I1A7 The difference bC2 the basis and the gift tax is income to TPs; At the time of the gift* TP sustained a debt to the government for the

amount of the gift tax* and kids discharged the debt* so it 2as income for the discharge of indebtedness; !c Insol0enc, and BR 4-0H.a'! there is no income from discharge of indebtedness if the indebtedness happens 2hen you are in bankruptcy under Title "" or insolvent; Ho2ever* for insolvency 2Co >@* the income from discharge of indebtedness can only be excluded to the extent of the insolvency immediately before the debt discharge; !d Affect on Basis! >asis in property includes the amount borro2ed to buy property* and amount reali9ed on sale of that property includes relief of indebtedness; Assumption of indebtedness is also included in basis of property boughtCreceived; p; +0 EME* example .0; !e %ontested8Dis+uted #ia*ilit,! If the amount of debt is disputed and then settled for an amount less than one 2hat party said it should have been* it is not necessary for the debtor to include in his taxable income any income from discharge of indebtedness; !f &ifts! if a gift is forgiven out of detached and disinterested generosity* the debt forgiveness is a 6"I+ gift and therefore not taxable; !g Iarin 02 %ommissioner !"FI !i &ACT(7 TP* Compulsive gambler accumulated H$;0M gambling debt at a casino; 1, la2 says it 2as unenforceable* illegal gambling debt; Casino and TP settle for HFII?; I@( said he had H+;/M income from the discharge of indebtedness; !ii H=J<I1A7 TP did 1=T have income from discharge of indebtedness; It 2as not debt under 6"I.!d !" bCc TP 2as not liable for it !because 1, la2 prevented the casino from holding him liable for it and did not hold property sub:ect to the debt; He paid the HFII? for 2hich he 2as legally responsible* and since he 2as legally obligated to no more* there 2as no income from discharge of indebtedness; <=@A1 (AO( >A<7 the definition is not keyed to rule of inclusion6"I. is a rule of exclusion; Contested liability doctrine !2herein if a TP* in good faith* disputed the amount of a debt* subse)uent settlement of the dispute 2ould be treated as the amount of debt cogni9able for tax purposes 7 it follo2s that 2hen a debt is unenforceable* the amount of the debt and not :ust the existence of obligation to pay it is in dispute- even unenforceable gambling debts are usually collected in part; The parties attached a value to the debt lo2er than its face value that 2as not set until the settlement; Therefore the debt 2as a contested liability and there is no discharge of indebtedness under this theory; <=@A1 (AO( >A<7 this doctrine only applies 2hen the amount of debt is in )uestion* 2hich it 2as not here; Nonrecourse De*t! !a Almost al2ays secured by property- debtor not personally liable for repayment* so foreclosure is the common method of recovery by creditor; !b %rane 02 %ommissioner!"%F !2ith rounded off numbers by <oran !i &ACT(7 TP inherits land and building in "/$+ 2ith a &MK of H+FF?- his basis is stepped up to that amount; Jand and building 2ere fully mortgaged 2ith a debt of H+FF?; TP claims a total of H+F? in depreciation deductions

for a fe2 years* and in "/$. sells the property for H+FII cash and the assumption of the mortgage by the buyer; !ii TP A@A'ME1T(7 the property she inherited is not the land and the building* but the e)uity in the land and building##HI since it 2as fully mortgaged; (he claims her only gain 2as the H+FII* and admits she shouldn8t have taken the H+F? in deductions but that it is too late to do anything about that; !iii H=J<I1A7 TP took the deductions and on the sale the government is entitled to recapture that benefit; Here8s ho2 it 2ill happen7 Her original basis in the property under 6"I"0!a is H+FF?* the &MK at the time of inheritance; An ad:ustment to basis under 6"I"%!a !+ 2ill be depreciation* so her ad:usted basis is H+$/? !H+FF?#H+F? The amount reali9ed is the cash plus the discharge of indebtedness* so H+FE*FII !H+FII plus H+FF? This 2ould be easy if it 2as recourse debt* a no brainer The court decides this is the case even though it 2as non#recourse debt; Her gain* therefore* is H+E*FII !H+FE*FII minus H+$I? ; This happens to be e)ual to the depreciation deductions she took plus the cash she got from the buyer; !iv <=@A17 There is another approach the court could have taken7 they could have agreed 2ith Crane that nonrecourse debt 2ould never figure into basis at the front or be part of gain at the back end There 2ouldn8t be any need to recapture the depreciation deductions bCc she 2ouldn8t have had the right to take them in the first place; "n the long run# the court$s %ay is more advantageous to the &'; TP gets the tax benefit at some point* and better to get it sooner as depreciation deductions than later 2hen you sell Time value of money issue* better to have nonrecourse debt treated as part of basis This case actually fueled the rise of tax shelters* giving deductions to those 2ho invest 2Cout real risk; !c Estate of Fran(lin !"E"* notes case !i &ACT(7 investorsCdoctors 2ant to shelter money from income* form an investment partnership 2hich buys motel appraised at H%II? for HEF? cash and H";+M in nonrecourse debt; Joan called for H/?Cyr interest- they leased motel back to sellers* 2ho made H/? lease payments on it; As a practical matter what the sellers sold to the investor/doctors for $ !" was the right to ta#e the depreciation deductions$ Partnership claimed the H";+M 2as their basis and take depreciation on that; Pretty clear that in $I years they plan to 2alk a2ay from debt* the sellers 2ill foreclose and get the motel back; !ii H=J<I1A7 The sale 2as a sham5there 2as no intent for the property ever to change hands; This 2as typical of most tax shelters though this one pushed the envelope a bit more; In cases like this* %here the &' has inflated nonrecourse debt# only the amount of recourse debt e(ual to the

)*+ of the !ro!erty %ill be included in basis ,along %ith any cash !ayments by &'-; !d %ommissioner 02 Tufts !"EF !2ith rounded numbers by <oran !i &ACT(7 (imilar to Crane* but the &MK 2as less than the debt* but not an abuse case like &ranklin- instead* the value of the property dropped naturally; Cost basis in "/EI of H"*./F*III- H0F? cash investment and nonrecourse debt for H";.FM; TP claimed a depreciation deduction in "/E" and "/E+ of H00I?* making their ad:usted basis H"*00F*III; In "/E+ they basically give property a2ay bCc &MK has fallen belo2 debt- buyer gives negligible cash and assumes debt 2hen it is H";0M; !ii H=J<I1A7 as in Crane* the amount realized includes amount of nonrecourse debt the buyer assumes; (o amount reali9ed is H";.FM* ad:usted basis is H";0FFM !H";.M minus H00I? ; That means the gain is H$/F?; This could also be seens as the depreciation deductions TP took minus the cash they put in* H00I? # H0F?; #' Ille)al Income " &il*ert 02 %ommissioner !".I !a &ACT(7 TP took H";/M 2Co permission from his co; to finance a merger; Ja2yers told him to give the co; a promissory note that he8d pay it back and pledge his o2n property as security; Company fails to perfect its security interest* so it ends up behind the I@( in priority on TP8s property; VP is 2hether TP should be taxed as a thief of borro2er; !b JAD( !i THIEKE(7 if you steal money and keep it* you have income from the theft* same if you steal and promise to pay it back in that year; If you steal and ACT'AJJO repay in same year* no income from the theft; !c H=J<I1A7 This is not a typical embe99lement case- TP not taxed as thief bCc he 2as not self#interested in embe99lement and bCc he meant to pay it back; !d <=@A17 the holding seems funny because TP had actually pled guilty to criminal charges as a result of all this business; This case is an outlier in realm of illegal income- most is considered taxable !robbery* moonshining* prostitution* counterfeiting* etc ; "' Tax Exem+t Bonds " 4-0>! exempts interest on state* municipal* and other such bonds for TP 2ho holds themCgets the interest from them; + It is the locality that benefits5the interest rates are lo2er on tax#exempt bonds* and the difference in interest is a subsidy to the locality from the federal government; $ This starts to break do2n because not everyone is taxed at the same rate7
Tax Rate FIG +FG %or+orate Bond Rate "IG "IG @3at t3e, 1ill ta(e to *u, tate8#ocal FG E;FG %ost to Feds FG =n FIG taxpayers7 FG =n +FG taxpayers 7 +;FG Taps out at FG still !less for lo2er brackets Benefit to tates FG +;FG on all taxpayers Benefit to Tax+a,ers 1one &or FIG taxpayers7 +;FG &or +FG taxpayers7 IG &or FIG7 0G &or +FG7 ";FG &or "IG7 IG

"IG

"IG

/G

"G

!a Jocalities have to increase interest rates to attract TPs at a lo2er rate- can8t issue different bonds for different tax brackets !b Above doesn8t change cost to government* but does reduce subsidydifference goes to TP in highest tax brackets; III' TI"IN& A' Reali5ation of &ains -' Policies *e3ind not taxin) until Jreali5ationK !a Ji)uidity issues !b Aain could evaporate !although this could be solved be a deduction for loss if it does evaporate !c Kaluation problems !d Also* in terms of economic#only income gives some TPs control of 2hen they are going to pay tax that other TPs don8t have + Eisner 02 "acom*er !$E* +"I !a &ACT(7 TP had shares of Co;* and Co; issued FIG stock dividend !for every t2o shares* TP got one free ; !b 1=TE7 There can also be cash dividends* but this 2as a stock dividend; !c I@( A@A'ME1T( that she should be taxed on the dividend !i TPAs 2ealth increased by virtue of the dividends !ii Even if she8s not richer* the fact of the distribution is a reali9ation of 2ealth that accumulated in corporate form !iii They don8t need reali9ation even at all5an increase of 2ealth at corporate level taxable to TP as shareholder !d H=J<I1A7 the dividend is not taxable income; (tock dividend doesn8t make holders any 2ealthier* :ust changes the form of their 2ealth; The "%th Amendment re)uires a reali9ation event and there 2asn8t one here; There is also a li)uidity problem* and the chance that the benefit could evaporate; Ho2ever a cash dividend 2ould be taxable7 there 2ould be no li)uidity* valuation problems and no chance it could evaporate; $ $el0erin) 02 Brunn !+I% !a &ACT(7 TP* o2ner of land* leased it to renter in "/"F- in "/+/ renter demolishes building there* builds a ne2 one; In "/$$ renter defaults* lease is abandoned; !b JEAAJ <I(P'TE7 I@( says TP has income as a result of "/+/ improvement* as the abandonment of the lease 2as a reali9ation event; !c H=J<I1A7 abandonment 2as a reali9ation event and TP should be taxed on income from improvement to land; !d <=@A17 this is difficult to reconcile 2ith Macomber; Though the TP stipulated to value of improvement* abandoning a valuation argument* it 2as still an illi)uid gain and certainty of gain not solid; .e' #e)islati0e res+onse to $el0erin) !i 4-0<! rule of exclusion7 lessor8s gross income doesn8t include value of improvements to property by a renter 2hen that lease ends; !ii 4-0-<! companion provision5basis 2on8t change on account of income excludable under 6"I/; !iii These rules cut in favor of the TP* allo2ing more control over 2hen they 2ill pay the tax; 0 @oodsam Associates 02 %ommissioner !+""

!a &ACT(7 Dood bought property for H+/%*0II* incurring a recourse loan; Then Dood refinanced 2ith a H0II? nonrecourse mortgage; Dood then donated property to TP* her company; In "/$$ Dood defaulted on the loan; !b TPCDood A@A'ME1T(7 Dhen she got another loan from recourse to nonrecourse* it 2as a reali9ation event; !c H=J<I1A7 the change in mortgages 2as not a reali9ation event5she 2as the o2ner of the property before and after the refinancing; Court is using o2nership* rather than policies arguments* as the test; !d <=@A17 Ho2ever* usually o2nership refers to holding upside and do2nside5 2hen she changes to nonrecourse she no longer holds do2nside; It8s sort of like she sold the property to the bank for H0II? and she had the option to buy it back for that much; Court doesn8t go this route; F %otta)e a0in)s Association 02 %ommissioner !+"F !a &ACT(7 TP is an (MJ that holds mortgages; It holds many mortgages less valuable than they used to be bCc of high interest rates; TP sells its mortgages and buys others from other banks to get a loss for tax purposes* but at the same time trying to avoid reporting losses to retain certification by bank regulatory board; TP is selling /IG participations of their mortgages and buying /IG participations of other mortgages* because unlike selling 2hole mortgages this is an invisible transaction; !b H=J<I1A7 The test of 2hether an exchange is a reali9ation event under 6"II"!a is 2hether the mortgages TP received 2ere materially different from those it gave up; Here they 2ere* bCc the mortgages and houses under the mortgages 2ere different; !c <=@A17 (ee non#recognition rules belo2- if they had been in place* this 2ould have fallen under one of them one of the exceptions to the non#recognition rule; B' Reco)nition " Reco)nition Rule! 4-00-.c'! the entire amount of a gain or loss under 6"II" 2ill be recogni9ed; . recognized gain or loss is a realized gain or loss that &' is going to take into account for ta !ur!oses; + Non:Reco)nition Rules !examples 7 !a #i(e:;ind Exc3an)es 4-0>!i 4-0>-.a'.-'! if there is a like#kind exchange* no gain or loss recogni9ed; T2o farmers 2ho trade their farms* e;g; Improved real property and unimproved real property are considered like kind if they are both held for productive use in a trade or business or for investment; Treasury @eg; 6";"I$"!a #"!b ; !ii Exce+tions 4-0>-.a'.2'! makes exceptions to 6"I$"!a !" ; &or example7 4-0>-.a'.2'.A'! <oesn8t apply to stock in trade or other property held primarily for sale; 4-0>-.a'.2'.%'! <oesn8t apply to securities or evidences of indebtedness or interests; .iii' Boot 4-0>-.*'! if an exchange is partially an exchange for like kind property and partially something else !boot you recogni9e the gain to the extent of the &MK of the boot !or reali9ed gain if reali9ed gain is less ; 4-0>-.c'! if there is boot received along 2ith like#kind property* a loss 2ill not be recogni9ed

1et relief of indebtedness is treated as boot under 6"I$"* and it is additional to cash boot; .i0' Basis 4-0>-.d' No Boot! the basis of the property AIKE1 is the basis in the property received in the exchange !i;e; each party keeps their old basis ; Boot TP 13o )ets *oot! the basis of non#cash property TP gets 2ill be the basis of the property TP gave in exchange minus cash TP receives* plus the amount of gain or minus the amount of lost that is reali9ed and recogni9ed; a; That basis is allocated among like#kind property and non#cash boot received by TP- the non#cash boot8s basis is its &MK; TP 13o )i0es *oot! the basis of the ne2 property TP AET( in exchange 2ill be the basis of the property TP gave plus any cash TP paid for the exchange; !b In0oluntar, %on0ersion 4-0>>! Aain not recogni9ed on involuntary conversion of property; Dhen conversion is to dissimilar property* gain 2ill be recogni9ed but TP gets a period of time to buy like property so it 2on8t be; TP can al2ays* ho2ever* recogni9e J=(( on involuntary conversions !generally in the amount of basis in the property ; !c 4-0>9! AainCloss from exchange of life insurance policies or other annuities non recogni9ed; !d 4-0>6! AainCloss from exchange of stock in same corporate not recogni9ed; !e 4-0>=! AainCloss from exchange of '( Treasury obligations for others !f 4-0C>! AainCloss not recogni9ed 2hen any officer or EE of executive branch of federal government has to sell property to comply 2Cconflict of interest la2s C Boot and Basis !+$" " Exam+le! C has Property A 2ith a basis of HFI and &MK of H/I- < has Property >; They exchange; !a If > has a &MK of H/I* it 2ill :ust be a property exchange; C 2ill reali9e a gain of H0I but it 2on8t be recogni9ed bCc there 2as no boot and it 2as an exchange of like#kind property; >asis in > 2ill be HFI; !b If > has a &MK of H%I and comes 2ith a H$I boot* C8s reali9ed gain 2ill still be H0I* his recogni9ed gain 2ill be H$I; >asis in > 2ill be HFI; !c If > has a &MK of H$F and a cash boot of HFF* C8s reali9ed gain is still H0Irecogni9ed gain 2ill be H0I because it is the lesser of the boot or reali9ed gain; >asis in > 2ill be H$F; !d This is basis doing 2hat it should7 keep track of 2hat TP has been taxed on and 2hat TP still o2es in tax; + Lordan "ars3 02 %ommissioner !++E !a &ACT(7 TP o2ned property on 2hich he operated a department store 2ith a basis of H0;.M; He sold the property for cash !H+;$M* the &MK of the property at a loss then leased it back from buyer long#term for fair rent so as to keep running the store; TP 2anted to deduct the loss but I@( said it 2as an exchange of like property5a fee interest for a long term lease !@egs 6";"I$"!a #"!c says a long term lease is e)uivalent to a fee ; !b H=J<I1A7 The transaction here 2as a sale !2hich means the court doesn8t have to decide 2hether the regulation 2as reasonable * not a like#kind exchange; Here

the TP made an unconditional conveyance to a stranger- this 2as more than a change in form of o2nership* it 2as a change in amount of o2nership in 2hich he closed out on a losing venture; Aenerally* exchange means the giving of one piece of property in return for another* not the return of a less interest in a property received from another !2hich is 2hat basically 2ent on here ; $ Re0enue Rulin) HC:-C9 !+$. !a &ACT(7 TP 2as an airline* held operating certificates to service certain routes; <eregulation Act made these certificates much less valuable; !b H=J<I1A7 1o deductible loss to TP under 6"%F!a ; 1o closed transactioncertificates not totally 2orthless and TP still in possession of them; !c <=@A17 TP probably should have been advised to abandon certificates* 2hich 2ould have been a closed transactionCidentifiable event* or done a Cottage (avings#style s2ap* though it 2ould have been inconvenient here; !d 4-69.a'7 re)uires a closed transaction fixed by identifiable events; Here the TP did not sell or abandon as completely 2orthless its route authorities- diminution in value is not the same as elimination or abandonment of a 2orthless asset- and the TP8s operating rights remained unchanged even though more competition 2as introduced; 0 O+en Transactions! Burnet 02 #o)an !+0% !a &ACT(7 TP o2ned "? shares of mining co; stock 2ith a basis of H".I?; Co; bought TP8s shares for H"+I? in cash and a promise to pay her 2hat they got from the ore !undetermined amount ; !b TP A@A'ME1T7 TP should be allo2ed to recover basis before re)uired to recogni9e income; !c I@( A@A'ME1T7 It is a closed transaction 2orth H++I?* so TP has met her basis and got H0I? in income; !d H=J<I1A7 It is an open transaction* TP is correct- the promise for future money payments 2as not e)uivalent to cash bCc it is uncertain so the transaction is still open; !e <=@A17 The court 2as a little 2rong in disregarding that there 2as some present value to the promise to get money later; TP could probably sell that right or collect the payments as they come* so the court8s approach here is very generous to TP; D' Accountin) "et3ods " Installment "et3od !+FI !a 4C9>! 2here there8s an installment sale* TP can take amounts paid and allocate it bC2 the basis and the income recogni9ed; !b Ratio! gross profit divided by contract price creates a percentage to allocate ho2 much of each payment is gain and ho2 much is basis; (o Payment S times !gross profit divided by contract price is the amount of income TP recogni9es each year they receive a payment; 60F$!c ; !c Installment ale! 2here payments straddle at least t2o taxable years; TP can opt#out of installment method for installment sales under 60F$!d ; !i Promissor, Note Not a Pa,ment /nless it is payable on demand or readily tradable; 60F$!f !$ ; =ther2ise there are li)uidity problems 2ith calling it a payment; If you sell in Oear =ne and :ust get a regular promissory note not for a later year* not an installment sale;

%as3 "et3od! TP generally 2ill include an item in gross income 2hen actually received or made available for receipt and 2ill deduct an item 2hen actually lost; Individuals almost al2ays on this method; $ Accrual "et3od! Jarge business normally on this; Jooks to 2hen the right to receive is accrued and the obligation to pay is accrued- that determines timing of income and deduction; "/I EME; E' %onstructi0e Recei+t and Related Doctrines " Em+lo,ee Deferred %om+ensation Arran)ement! !a Contract bC2 E@ and EE that E@ 2ill pay some or all of EE8s compensation after it is earned; !b <ifferent than tax#)ualified plan- often called non%&ualified plans; !i 1on#)ualified plans cover only executive and HCEs- federal la2 forbids them covering rank and file; !ii Tax difference is that assets going into )ualified plans gro2s tax exempt !dividends* interest* etc not taxed as they accrue ; 1ot for non#)ualified; .c' Exam+le !i If interest is at %G7 Dhen an executive has earned H"II at Oear " and is to be paid at Oear F* the E@ really has to put do2n H""" at Oear " in order to be able to pay EE H"II at Oear F; If it 2as in the hands of the EE from Oear "* then by Oear F he 2ould only have HE/ after taxes; !ii Therefore* the tax benefit in connection 2ith deferred compensation is not funded by the government* but the E@; It8s :ust a 2ay to increase compensation; !d If an EE has control over timing or security of the deferred compensation arrangement* then the compensation 2ill be included in income 2hen earned; !i %onstructi0e Recei+t Doctrine! a cash method TP must include in income an unpaid amount unless their rights in that amount are substantially restricted; !ii Economic Benefit Doctrine! cash method TP must include an amount in income if E@ has put the amount in a trust* or other2ise secured it for the benefit of TP beyond reach of E@8s creditors; !iii %as3 EEui0alence Doctrine! cash method TP must include in income any unpaid amount if rights to that amount can be pledgedCassigned for value; !e Amend 02 %ommissioner !+F$ et al !i &ACT(7 TP had a bumber crop of 2heat; TP contracted to deliver it to customer in "/00 and be paid in "/0F; I@( 2anted to include income in "/00 return* but TP said it should be in "/0F; !ii H=J<I1A7 TP is correct5by the time the contract 2as made* TP had no legal right to payment until "/0F and transaction didn8t happen until after the contract; %ase
Amend Pulsifer !+F. <rescher !+F/

Facts
(ale of 2heat in 800payment in W0F Pri9e money- vested bank account @etirement annuity for employees

#e)al Issue
Constructive receipt Economic benefit Economic benefit

Outcome
Taxpayer 2ins Aovernment 2ins Aovernment 2ins

Rationale
<eferral is pre#contractual* so the taxpayer had no legal right to payment in "/00 Irrevocable trust* set aside for taxpayer8s benefit (ame theory as Pulsifer5 E@ is setting up a legal arrangement that gives a

Minor !+%.

<eferred compensation held in trust* 2hich buys annuities @enegotiation of insurance commissions

Constructive receipt M economic benefit Constructive receipt M economic benefit

Taxpayer 2ins on both Taxpayer 2ins on both

=lmsted !+EE

current economic benefit to EE promise to pay in the future doesn8t trigger constructive rec- not secured from E@8s creditors5no C@ 1ovation5like Amend; The deferral is pre# contractual; He8s not turning his back on income* he8s renegotiating his deal; (o no C@; They also deny economic beneft;

!f Cases are looking :ust at TP 2ho receives the money* not both sides of the transaction; 2' #e)islati0e Res+onse to Enron !a At Enron* there 2as a 3haircut provision47 "IG penalty for taking money out of the deferred compensation fund but it could be done any time; The analysis 2as that such a significant penalty meant EEs 2ere not in constructive receipt of their unpaid compensation; !b 4C0<A! meant to ban haircut provisions and clean up the la2; !i 4C0<A.a'.2'.A'! deferred compensation can8t be distributed until end of employment* disability* death* specified time* change in o2nership* or unforeseeable emergency; !ii 4C0<A.a'.>'! there can be no acceleration of benefits5this is the part intended to ban haircuts; !iii 4C0<A.a'.C'.%'! you can delay benefits* but only a year in advance and only for a period of more than five years from 2hen originally earned; .i0' Penalt, If above rules aren8t follo2ed* all deferred compensation in past years and current year 2ill be includable in gross income under 60I/A!" !A ; There 2ill be an interest charge and penalty of +IG of income includable in gross income; 60I/A!" !> ; If you kno2 this* and do it any2ay* nothing to stop the company from picking up your tax liability; (o Enron could have happened even if this statute 2as in place; It8s not good; F' ?ualified Pension8Profit 3arin) Plans +22=0 " Personnel ob:ectives7 Enable employee loyalty and employee incentives !including investing in the employer8s stock- cf;* Enron Corp; ; + <efined benefit !<> plan7 employer agrees to pay fixed retirement benefits based* e;g;* !a on years of service and !b final pay amount; $ <efined contribution !<C plan7 amount contributed based on formula !e;g;* FG of current compensation and the amount paid on retirement is based on investment returns; C' ?ualified +lan income tax results! !a Employer deduction for plan contributions; !b 1o current AI to the employee#participant- AI inclusion upon later distribution to retiree; !c 1o AI for investment returns received by intermediary holding entity !e;g;* trust ;

!d 1on#tax benefit X funds are protected from employer8s financial risks !although possible actuarial underfunding for <> plans ; 9' #imitations on Eualified +lan structurin)! !a 1on#discrimination rules X cannot favor highly#paid employees !but social security integration ; !b Kesting X benefit becomes nonforfeitable- cf;* effect of termination before retirement; !c &unding X infusion of contributions into a separate trust enables security of funds; !d Jimits on contributions made by employer; &' +ecial Retirement Plan tructures +22=>:C " (elf#employed persons X use a ?eogh plan 2hen only one !or several employees; + >ut* other mechanisms for corporate plansB $ I@As X individual retirement accounts X e;g;* 2hen employer not providing benefits; 60I.; 0 @oth I@A Xnondeductible contributions* but non#inclusion for accruals and distributions; !a Penalties for early 2ithdra2als* M !b @e)uired minimum distributions !EI Y ; $' Pro+ert, Exc3an)ed for er0ices " 4H>.a'! if there is a transfer of property in exchange for performance of services* the person getting the property must include the &MK of the property minus the amount they paid for the property in their gross income at the time 2hen the property is transferable or not sub:ect to a substantial risk of forfeiture; !a Pro+ert, not 0ested! 2hen property is not vested * the above has not yet been triggered* put EE can elect to include it at the time of receipt and o2n it free and clear for tax purposes at that time; 6.$!b ; !b Deduction! E@ can deduct the payment in property 2hen EE includes the property in their gross income; 6.$!h ; 2' toc( O+tions !a O+tion @IT$ NO RAF"V 4H>.e'.>'! 6.$!a does not apply to the transfer of an option if the option has no readily ascertainable market value !@A&MK ; .i' Treasur, Re) 4 -2H>:= EE is taxed on value of the option !that is 2hat they saved by using it either 2hen =ption is exercised =ption is sold Example =ption for "II shares at HEFCshare (pot price 2hen exercised5H"IICshare Taxable compensation income L H+FII !E@ cannot claim a deduction on this 2Co a D+ but it is also not capital gains !b O+tion @IT$ RAF"V 4H>.e'.C'! 6.$!a doesn8t apply to the transfer of property pursuant to the exercise of an option 2ith a @A&MK at the time of the grant; !i (o if you 2ere taxed on the @A&MK of an option 2hen you got it* you exercise the option 2ithout further taxation; !ii Oou can still be taxed !most likely capital gains tax 2hen you sell the (HA@E( you buy 2ith that option* ho2ever* and your basis in those shares

2ill be the @A&MK at the time of inclusion in your income plus 2hatever you actually pay for the shares; =PTI=1( Z Z @A&MK [ grant 1= @A&MK [ grant Z Z 6.$!a applies to option 6.$!a applies to stock 2hen exercised !c %all O+tions! right to buy5almost all EE stock options are call options; Aenerally exercise price is the same price as the &MK on the day the option is granted; !i Aenerally no @A&MK to a call option !ii Exam+le7 in "/// option to buy "II shares at HEFCshare* in +II+ 2hen TP vests they are selling at H"IICshare* gain 2ill be H+FII; That income to him is :ust compensation income to TP under 6.$ and 6%"!a !" - no taxable event in "///* bCc the option had no @A&MK; >' IR Notice 200>:C= And Tax 3elters !a Aovernment challenged stock option shelters on t2o grounds !i (ale to a limited partnership only made up of family members is not an arm8s length transaction- the original o2ner of the stock shares retains o2nership 2hether he 3sells4 to the partnership or not !ii Installment sale does not )ualify as such 2hen paid for 2Ca promissory note .*' Exam+le !i (chmidt gets the options from Aoogle and sells them to (chmidt &amily Jimited Partnership !ii (chmidt &amily JP gives (chmidt a $I#year installment note 2ith a balloon payment at the end !iii Dhen vested* the (chmidt &amily JP gives Aoogle H$IM for the options and gets H%IM 2orth of stock .i0' "ain Ideas! The note is not a payment* there is nothing to include in the return that year The partnership is not an EE of Aoogle* so 6.$ does not cover this transaction !c 1=TE7 most options are not transferable to others except through divorce or be)uest; !i Tax shelters re)uired companies to make internal changes in their stock optsions !ii This is not really a probably anymore after this ruling 0 %ramer 02 %ommissioner !+/0 !a &ACT(7 TP founded a privately held company in "/E+- bC2 "/E. and "/." it 2as neither publicly traded nor registered 2Cthe (EC and it 2as held by "FI#+II shareholders; In "/E. it issued TP an option to buy FI? shares at HFICshare* as long as it 2as exercised only in +IG increments and only as long as he 2as still employed there- there 2ere also some transfer restrictions; In "/E/ the co; issued TP another option to purchase 0$/I shares at H.Cshare* and some options to some other execs; The co; issued all of these options in recognition of services they provided to the co* and the delayed vesting 2as intended to induce their continued employment; 1one of them ever exercised the options; Then TP got bad tax

advice from an accountant* 2ho told him to file 6.$!b elections 2ith the I@( for the options; The TP declared HI value on the options even though he thought they 2ere 2orth something* because the tax attorney had advised him that 6.$!b might not apply 2Cout a readily determinable &MK and he 2anted them to have a readily available &MK; !b H=J<I1A7 Treasury @egulation 6";.$#E is valid and clearly the options in )uestion did not meet the definition of readily ascertainable &MK !+/E ; Therefore* 6.$ did not apply to the transfer and the gain from the sale of the options 2as ordinary income not capital gain; I' Transfers Incident to "arria)e F Di0orce " /nited tates 02 Da0is !$I+ !a &ACT(7 TP and his 2ife got divorced and as part of the settlement TP gave 2ife "III shares of stock of <uPont; 1ot a community property state* so all property during marriage not :ointly o2ned by husband and 2ife; !b H=J<I1A7 Transfer 2as taxable event !i;e; TP had to reali9e and recogni9e gainCloss since they 2eren8t hers until <avis transferred them to her* and the exchange 2as for something of e)ual value !her marital rights ; !c <=@A17 this is an asinine result* saying that her marital rights 2ere 2orth the same amount as "III shares of stock; !i The court is trying to fit the case into one of t2o paradigms Community property state7 no reali9ation event bCc they both already o2ned the shares If they had never married and he sold the stock to her for cash* there 2ould be a reali9ation even in the sale; !ii The court is basically saying that bCc it8s not a community property state* it8s closer to the second scenario; 2' #e)islati0e Res+onse to %ommunit, Pro+ert, Dis+arit, !a 4-0C-! !non#recognition rule there 2ill be no gain or loss recogni9ed on a transfer of property from in individual to a spouse or former spouse; !b Exam+le! Ignoring 6"I+"* D buys house for HFII? before marriage to H and is no2 giving it to H in their divorce 2hen 2orth H"M;
Da0is Rule HFII? reali9ed M recogni9ed gain 1o taxable income* basis of H"M under 6"I"+ H$II? taxable gain at time of sale 4-0C- Rule HI recogni9ed gain under 6"I0"!a HI recogni9ed gain under 6"I0"!b !" * basis of HFII? under 6"I0"!b !+ H.II? taxable gain at time of sale

Tax treatment of 2ife Tax treatment of husband Tax conse)uence of husband selling for H";$M

!c 1o special rule like 2ith gifts5there is a carryover basis 2hether there is a gain or loss; !d <oes not apply if the transferee spouse is a non#resident alien- in that case* the <avis rule applies; 6"I0"!d ; Farid:es: ultane3 02 %ommissioner !$IE !a &ACT(7 H transferred stock to his 2ife before they got married 2orth H.II? 2ith a basis of HI;"F and 2orth H"I?Cshare at the time of transfer; This 2as a pre#nuptial agreement; D sells for H"/Cshare after divorce; !b H=J<I1A7 This is more like a sale than a gift bCc they 2ere both getting something valuable;

!c <=@A17 court still struggling as in <avis; Here it 2ould have been really bad for D if it had been declared like a gift* bCc she 2ould have had a carryover basis of HI;"FCshare making a huge gain; 0 Die5:Ar)uelles 02 %ommissioner !$"F !a &ACT(7 Ex#H in arrears for H0FII in child support* ex#D deducted it and treated it as a non#business bad debt; !b H=J<I1A7 <eduction not allo2ed* because no basis in the debt5can only deduct bad debt if there8s basis in it; !c <=@A1 !i Dhat does it mean to have basis in debtB There are t2o paradigms here7 Child support means an obligation to pay H$EII and she loans that to him* 2hich he uses to support the kids* and never pays it back; Court 2ould recogni9e THI( as creating basis in bad debt; There is no court order- he :ust says he plans to give her H$EII and then he doesn8t; 1o investment in debt here* and therefore no basis; !ii Court says it is more like +nd paradigm5but this is absurd; =f course she is out of pocket* every dollar he o2ed and didn8t give is money she had to pay; 9' Alimon, !a Aenerally alimony is taxable to the payee and deductible by the payor* 2hile child support and property settlements are not taxable to the payee or deductible by the payor; !b 4=- Rules )o0ernin) Alimon, and e+arate "aintenance !$""#$"+ !i 4=-.*'! defines alimony or separate maintenance as cash payments7 @eceived under an instrument of divorce or separate maintenance 6E"!b !" !A Dhere the parties have not agreed that the payment 2ill not be taxable to the payee and nondeductible by the payor !i;e; can8t 2aive rights to alimony beforehand ; 6E"!b !" !> Dhere the parties are not longer living together; 6E"!b !" !C ; Dhere payments don8t continue after the death of the payee spouse !other2ise they are more like property settlements ; 6E"!b !" !< !ii Alimony payments must not be for child support; 6E"!c ; If the payor has custody of and supported the children* there 2ould be no deduction for the cost of the support* so there is no :ustification for allo2ing the payor to deduct child support payments 2hen they are not the custodian; .iii' Excess Alimon, Rules 4=-.f' The la2 really discourages front#loading alimony payments* so only payments that are substantially e)ual for the first three years 2ill be treated as alimony "ain +ro0isions The amount of the excess !S for the first year is the excess of alimony paid in the first year !a minus the sum of the average alimony or maintenance payments made during the second year !b reduced by the excess for the second year !O ; 6E"!f !$ ; First Gear Excess .M' 6 a N OP* N , Q cR82 Q S-9;T The amount of excess for the second year !O is the excess of the alimony paid in the second year !b minus the alimony payments

made in the third year !c plus H"F?; 6E"!f !0 ; (econd Gear Excess .G' 6 * N .c Q S-9;' S R O !The excess amounts for the first t2o years must be included in the payor8s income in Oear $ !and may be deducted from the payee8s ; Rationale! <eprives people of the opportunity and incentive to turn property settlements into alimony The recapture rule is not re)uired if either party dies or if the payee spouse remarries by the end of the calendar year 2hich is t2o years after payments started and the payments end bCc of remarriage; Excess of the front#loaded payments are considered income to the payor !c 42-9! gives a deduction from income for alimony payments and incorporates the 6E"!b definition as long as it is includable in the income of the payee; L' %onsum+tion Tax -' Economic Definition !a Income L Consumption plus savings !b (avings L Income minus consumption !c Consumption L Income minus savings 2' Pu*lic Polic, !a There have been proposals to move to a consumption#only tax; Arguments for7 !i Dould reduce the overall tax burden on saving money !ii Dill lead to economic gro2th by giving bigger return on investments !iii (impler and easier to administer 'owever it is not that easy to draw lines b/w consumption and investment/savings as many might say !b Arguments against !i E)uity Hori9ontal e)uity7 similarly situated people should be taxed the same; (pecial tax preferences al2ays disturb it5e;g; marriage penalty; Consumption tax 2ould define ability to pay not by income but by 2hat they spend5is that the best 2ayB Kertical e)uity7 those 2ith a greater ability to pay should pay more; &lat tax on consumption raises some issues 2ith this a; 1ot progressive b; >urdens those at the lo2 end 2ho spend a higher portion of their 2ealth c; Even a progressively structure consumption tax 2ould have the second problem 1ot everyone cares about vertical e)uity* though; >' @3at does consum+tion tax loo( li(eB !a There are many countries 2Cnational consumption tax* but they also tax income !b (ales tax !c Dage tax !d KAT !levied at each stage of production on value#added- European thing !e S tax on net cash flo2 of business and 2ages people earn7 this one allo2s for a progressive structure 0 Transition Issues7 a transition to consumption only tax 2ould affect basis;

Al1a,s consum+tion tax rate 6 90U Time - earn S-00D in0est after:tax amount in land Time 2 sell land 13en F"V -90U of +urc3ase H"II from labor #H"II for investment in land L HI taxable H"FI sale proceeds; If you reinvest* HI taxable If you consume there is a HEF tax !H"FI x I;FI 1et after#tax amount of HEF

Al1a,s income tax rate 6 90U H"II from labor x I;FIL HFI paid in tax* HFI to invest in land HEF sale proceeds # HFI basis L H+F gain taxable at FIG L H"+;FI 1et after#tax amount of H%$;FI

%3an)e from income to consum+tion *81 Time - F Time 2 H"II from labor* o2e HFI tax* invest HFI in land HEF sale proceeds; If you reinvest* HI taxable; If you consume* you have no basis; HEF of proceeds so all HEF is taxable; (o you pay H$E;FI in taxes and have only net after#tax amount of H$E;FI

F "a7or reason 1e donAt! businesses and old people don8t 2ant their basis 2iped out; IV'DED/%TION AND PREFEREN%E A' Personal Deductions " &eneral rule! personal expenses generally are not deductible; 6+%+; Many exceptions; 2' Personal De+endenc, Exem+tions $ Non:Itemi5ers! @oadmap to taxable income for non#itemi9er !a Aross income !b Minus deductions allo2ed under 6%+ L ad:usted gross income !i These are 3above the line4 deductions !c Aross income minus standard deduction !i This is a flat amount indexed for inflation !ii Intentionally set higher than most 2ould have if they itemi9ed to encourage administrative ease !d Minus personal exemptions !i This is a deduction for the TP and each of her dependents Personal Exem+tion 4-9 @ationales7 a; >asic living expenses should be taken into account in determining ability to pay !i;e; they should be removed from the picture before such determination b; Expenses increase as the si9e of the household increases c; Administratively it is easier to give a standard number than try to determine in each given circumstance 2hat a family8s cost of living is Effects a; Increases threshold at 2hich lo2er income people don8t pay taxes b; Contributes to overall progressivity by creating a larger 9ero# bracket Phaseout7 TPs lose +G of the personal exemption for every H+FII of income over the threshold !currently H+"0*IFI for marrieds De+endents .c3ildrenD )randc3ildrenD ot3er Eualif,in) relati0esD or si*lin)s 13o are under -<D or full time students under 2C'2 4-92 To be a dependent* must7

a; Jive 2CTP for at least FIG of the year if the TP8s child !though temporary absences to attend school do not count to2ard being a2ay from home b; Have at least FIG of support paid for by TP c; <oes not provide half of o2n support i; (cholarships do not count as 3providing your o2n support4 so a child going to school on a scholarship full time can usually be a dependent d; @eird! a non#relative can be a 3)ualifying relative4 under 6"F+!d if they are not a )ualifying child of the TP and i; Has the same principal place of abode as TP ii; Has gross income less than the personal exemption amount iii; Aets more than half of support from TP !ii Combining this 2Cstandard deduction means many families pay no tax Jast year* the first H++*.II 2as not taxable and the personalCdependent deduction 2as H$+II; !iii Phase out at a certain income level !e E)uals taxable income 0 Itemi5ers! Taxpayers 2ho do itemi9e have the same roadmap but !c is minus itemi9ed deductions instead of standard deduction; !a They can take any deduction allo2ed in the code except the standard deduction; !b Must deal 2ith 6%E and 6%.; !i 6%E sets a floor on miscellaneous itemi9ed deductions7 you can only deduct them to the extent they are more than +G of ad:usted gross income; !ii 6%.7 if your ad:usted gross income exceeds a certain amount* you lose some of your itemi9ed deductions !those e)ual to $G of the amount of ad:usted gross income greater than the threshold amount ; Jast year the income amount trigger 2as H"0F*/FI; !iii There are no similar phase#outs or conditions for the standard deduction; !c Itemi9ation generally more valuable for people 2ith higher marginal tax rates5 on examB 9' ome T,+es of Itemi5ed Deductions !a %asualt, #osses +IF EME !i 6"%F!c !$ 7 an individual tax payer is allo2ed a deduction for purely personal loss if it arises from fire* storm* ship2reck* other casualty* or theft; Each casualty is allo2ed a deduction only to the extent it exceeds H"II; 6"%F!h !" ; 1et casualty losses in a year are only allo2ed to the extent they exceed "IG of ad:usted gross income; 6"%F!h !+ ; 6"%F!a 7 it is only the net loss that can be deducted !anything covered by insurance* etc; can8t be deducted* and it can8t be deducted if it reasonably might be reimbursed5that is it can8t be deducted until its clear it 2on8t be reimbursed or further reimbursed ; 6"%F!b 7 the deduction for individuals is the lesser of the ad:usted basis of the property* or the value at destruction- therefore if insurance covers the basis* there 2ill be no casualty loss deduction; Business %asualt, #oss! This is a 6"%F!c !a #!+ loss* and is not sub:ect to the H"II or "IG AAI limits; (uch uninsured losses are

allo2ed e)ual to the ad:usted basis of the property* even if it is greater than the &MK; !ii D,er 02 %ommissioner !$0$ &ACT(7 family cat started having fits- in first fit it broke a H"II vase; TPs claimed H"II casualty loss deduction; H=J<I1A7 the breakage 2as of ordinary household e)uipment by negligence or family pet; If they had allo2ed the deduction it 2ould have caused evidentiary problems in future cases; !iii %3amales 02 %ommissioners !$0F &ACT(7 TPs bought home next to =, (impson and the >ro2n#(impson murders happened 2hen the house 2as still in escro2; TPs 2ent through 2ith the sale; @ealtors and brokers told them it 2as very devalued and TPs claimed a deduction for loss of property value; H=J<I1A7 I@( is correct5there can be no deduction* it doesn8t fit 2Cin 6"%F!c !$ because it 2as not sudden* permanent* and didn8t involve physical damage; Ho2ever* the I@(#imposed negligence penalty 2as not upheld by the court; <=@A17 The suddenness re)uirement is probably a proxy for foreseeability; !iv Blac(man 02 %ommissioner !$F+ &ACT"7 There 2as a domestic disturbance- H found out D 2as cheating* broke some 2indo2s* and burned her clothes on the stove 2hich eventually destroyed the house by fire; HE 2as sentenced to community service; He then claimed a deduction for casualty loss of the house and its contents; H=J<I1A7 although the damage 2as sudden* permanent* and involved physical damage and 2as from fire 2hich is specifically mentioned in the statute* it 2ould frustrate the state8s public policy against domestic violence and arson to allo2 the deduction* so it is disallo2ed; !v The I@( challenges casualty loss cases as much as possible; !b Extraordinar, "edical %osts !$F% !i 42->.a' is the actual deduction Covers medical care for TP* spouse* and dependents to the extent they exceed E;FG of AAI; 6+"$!a ; Medical care includes everything but controlled substances* veterinary fees* cosmetic surgery; 6+"$!d ; <octor8s recommendation not re)uired* but helps .ii' @3at is medical careB Psychiatric treatment costs are deductible Treasury @eg 6";+"$#"!e !" !ii ; Cosmetic surgery to repair a congenital defect I( deductible; 6+"$!d !/ <ental 2ork Capital improvements for medical purposes are deductible to the extent they cost more than they add value; 1=T7 1=T health maintenance like aerobics lessons for someone 2ho isn8t sick !except annual diagnostic checkup costs are deductible

 1=T food and lodging 2hile a2ay for outpatient medical care !but travel costs and doctors fees are Ma:or issue in these cases is a line bC2 things people 2ould only spend money on if they 2ere sick; Ta,lor 02 %ommissioner !$F. a; &ACT(7 TP8s doctor told him not to mo2 his la2n for health reasons; The TP then claimed a medical expense deduction for the cost of his la2n care; b; H=J<I1A7 <octor recommended activities are not medical expenses 2here the expenses are not 3medical care;4 There is no sho2ing here that other family members couldn8t perform the activity; $enderson 02 %ommissioner !$F/ a; &ACT(7 TPs deduct depreciation for their hand#van used to transport their disabled son* considering the van a medical expense under 6+"$; b; H=J<I1A7 Medical expense is defined as the amount paid for transportation or medical care- depreciation is not an 3expense paid4 under the statute; c; 1=TE7 actually retrofitting the van to accommodate the son 2as a deductible expense under 6+"$* but since the depreciation did not involve outlay of cash it didn8t count; They should have deducted the entire cost of the retrofitting 2hen they did it; Oc3s 02 %ommissioner !$%I a; &ACT(7 A cancer patient* is told that having her children around might cause a recurrence of her cancer; Her husband* the TP* sends the kids to boarding school and deducts it as a medical expense; b; H=J<I1A7 This 2as a general family expense* personal in nature* and not deductible as a medical expense; If they had sent the DI&E some2here for rest and relaxation a2ay from the family* that might have been deductible as a medical expense; >ut people send their children to boarding school all the time for no medical reason; c; <I((E1T7 These expenses fall 2Cin the category if mitigation and treatment of disease- the deduction could be limited to the expense of the care of the children 2hen they 2ould other2ise be around their mother !e;g; not the expenses during school hours* but the room and boardB ; !c %3arita*le %ontri*utions 4-=- !$%% !i Appropriate donees for deductible contributions listed in 6"EI!c Must be a domestic entity Must be religious* educational* charitable* scientific* literary* etc; 1= part of the earnings of the entity can go to a shareholder !no private inurement Cannot be a political organi9ation (pecific types of organi9ations7

!ii

!iii

!iv

.0'

(upport of native Alaskans engaged in subsistence 2haling is deductible under 6"E"!n !<oran says this is a shameless lobbying result ; There is a deduction for .IG of any amount paid to an institution of higher learning if the deduction 2ould be allo2able but for the fact that TP receives as a result of paying such amount the right to purchase tickets for seating at an athletic event in an athletic stadium of such institution; 6"EI!J ; ,ust because something is a 6FI"!c !$ doesn8t mean that it is also a charity for purposes for deductible donations Jimits on the deduction in 6"EI!b Core group 2ith a higher limit in 6"EI!b !" !A * FIG of AAI is deductible if donated to these groups =uter group of donees 2here the deduction limit is EITHE@ $IG of AAI* =@ the balance of of the part of the first FIG not used on a charity in the core group; Contributions in excess of the deduction limitations can be carried over and deducted for the next five years; 6"E"!d !" ; Payments to a charity as a result of a court order do not )ualify for the deduction; u*stantiation! There is a substantiation re)uirement for some contribution* 2herein the donee organi9ation has to provide the donor 2ith a 2ritten substantiation of the donation for the donor to claim the deduction; 6"E"!f !. ; Donations of ca+ital )ain +ro+ert, 4-=-.e' !$%E Dhen TP makes a gift of property 2hose sale 2ould produce long#term capital gain* the amount allo2ed as the deduction is the full &MK of the property; In the case of a gift of property 2hose sale 2ould produce short#term capital gain or ordinary income* the deduction is limited to the TP8s basis in the property; Donations 1it3 +ri0ate o*7ecti0es or *enefits Otto1a ilica 02 /nited tates !$%. &ACT(7 TP claimed a charitable deduction for a donation of land to a local school district- it did so kno2ing that a school in that location 2ould mean that roads 2ould have to be built through its property 2hich 2ould provide TP 2ith benefits; The I@( assessed a deficiency on the grounds that the TP got a 3substantial benefit4 from the transfer of property* 2hich exterminated the charitable nature of the transfer; H=J<I1A7 A substantial benefits that 2ill exterminate the charitable nature of a donation is one that is greater than the benefit that inures to the general public from a transfer for a charitable purpose !i;e; if the TP gets a better benefit than the general good* they have received a substantial benefit; Here* the TP made that donation 2ith full kno2ledge that it 2ould be receiving a substantial benefit- it made the donation expecting an increase in the value of the rest of its property;

The charitable nature of the donation 2as here extinguished and no deduction 2ill be allo2ed; <=@A17 Intent seems to play a role here* as in <uberstein 2here intent of the donation had a part in determining 2hether something 2as a gift; >ut of course no charitable donation is made 2Co some expectation of a return; <onations to a church give you psychological satisfaction* donations to a university get you a library 2ith your name on it; ?uid Pro ?uo! &or any )uid pro )uo contribution over HEF* the charity must provide the donor 2ith a 2ritten statement that the entire amount of the donation is not deductible and must provide a good faith estimate of the value of the goods received !e;g; a tote bag from a P>( fund drive ; 6%""F; !vi O0er0aluation! There is a ma:or problem 2ith overvaluation of 2orks of art that are donated; There is a substantiation re)uirement for donations of property 2ith a value of greater than HF?; .0ii'@3at is Jc3arita*leKB Bo* Lones /ni0ersit, 02 %ommissioner !$E% &ACT(7 TPCschool discriminated on the basis of race in admissions and inter#racial dating; Claim that segregation is part of religious understanding; I@( @evenue ruling says racial discrimination in education is against public policy and thus schools 2ho do it don8t get tax exempt status; H=J<I1A7 the school not entitled to tax exempt status because of public policy and the I@(8s authority through the revenue ruling; To get tax exemption* a group must meet one of the eight categories in 6FI"!c !$ A1< serve a charitable purpose; Also* the government should not give a subsidy to racially discriminatory organi9ations; <I((E1T7 the 3ors4 in 6FI"!c !$ Psee belo2Q are dis:unctive and meeting any one category is enough to get tax exemption; <=@A1 a; @eagan had tried to repeal the revenue ruling that focused on public policy and replace it 2ith legislation that amended 6FI"!c !$ to prohibit racial discrimination; >asically @eagan didn8t 2ant racial discrimination* but also didn8t 2ant the I@( deciding 2hat 2as and 2as not a charitable purpose; b; The dissent is actually correct that charitable purpose is :ust one of eight categories and not defined as overarching in the statute* but of course the result here is correct; c; Dhy didn8t they :ust say it 2as unconstitutional for the school to practice racial discriminationB i; Probably bCc it might cause problems in provision of subsidies to any religious organi9ation through tax subsidies; ii; <on8t 2ant to bring up the Constitution* 2hich also contains the Establishment Clause; 490-.c'.>' gives the basis for being a tax exempt organi9ation5very similar to list in 6"EI of groups of to 2hom TP can donate and deduct those donations; There are eight* ESCJ'(IKE categories7

 @eligious Charitable (cientific Public safety testing Jiterary =r educational purposes =r amateur sports =r prevention cruelty to children or animals .d' Deductions for Interest !i &eneral rule! there are no deductions for personal interest paid or accrued during the taxable year; 6"%$!h !" ; !ii Exce+tions! found in 6"%$!h !+ ; Interest allocable to a trade or business7 cost of producing income from the trade or business and therefore a business expense* unless it is an expense allocable to the business of being an EE; 6"%$!h !+ !d 7 TP can deduct interest 2hen borro2ing to buy or improve a home* or borro2ing against TP8s home !like a mortgage ; This is a subsidy to home o2nership lobbied for by national association of realtors; !iii 4269.a'.2'! there can be no deduction for interest 2here income is exempt from taxes bCc that 2ould be double tax avoidance; A little 2eird bCc it treats tax exempt bonds as though the subsidy goes to the TP* 2here in fact it goes to the municipality; !iv 4-6>.d'! 2hen investment interest debt is in excess of income* TP can carry the interest deduction allo2ance for2ard to future years; <eduction can8t be taken until it starts to produce income; .e' Deductions for Taxes !i <eductions are allo2ed for state and local income taxes and personal property taxes; 6"%0 (tate and local sales taxes can be deducted but only if the TP gives up the deduction for state and local income taxes 'ser fees are not treated as taxes and are not deductible &oreign income taxes are treated as credits under 6/I" !ii Polic,! (hould certain outlays be treated as reductions in arriving at proper definition of net income and* if not* is a deduction a sensible device for achieving some desirable goal extraneous to the tax systemB tron)est ar)ument FOR deductions! taxes are involuntary and do not buy personal consumption* so they should be deductible "ain Ar) FOR deduction! <ifferent states rely on different forms of taxation and residents of those states that choose to raise revenues through property or sales tax should not be 2orse off than those 2ho rely on income tax; Ar)uments a)ainst! Property taxes are sort of voluntary; The C> says they add no value to the house* but is that trueB !f tudent #oans! good policy argument for allo2ing total deduction since you are investing in human capital; 6' Ot3er Personal Deductions8Exclusions

ale of Personal Residence 6"+"7 allo2s )ualifying TP to permanently exclude from income up to H+FI? from sale or exchange of principle resident !i TP must have o2ned and occupied the property as a principal residence for at least t2o of the five years prior to the sale or exchange; 6"+"!a ; !ii TP can )ualify for the exclusion only once every t2o years; 6"+"!b !$ ; !iii TP 2ho does not meet both above re)uirements may )ualify for a reduced exclusion under 6"+"!c if TP had to move bCc of a change in place of employment* health* or other unforeseen circumstances; If TP can8t satisfy occupancy re)uirement* may exclude H+FI? times P!the period of time in the five years before the sale during 2hich the TP did o2n and use the residence as a principal residence divided by t2o years;Q If TP has already excluded gain under the section 2Cin the past t2o years* the TP can exclude H+FI? times the period of time bC2 the sale and exchange of the previous principle residence for 2hich the exclusion 2as recently used divided by t2o years; B' Tax %redits " Definition! A tax credit is a subtraction from the net tax due !as opposed to a deduction* 2hich is a subtraction from the income to be taxed !a &ormulas7 .i' &ross income minus deductions 6 taxa*le income .ii' .Taxa*le income times tax rate' minus tax credit 6 total tax due !b Almost al2ays a true tax preference5based on policy* not :ust definitions of income !like exclusion for amounts borro2ed* deduction for business expense are about definition of income* charitable contributions and interest on state and local bonds is purely about policy ; 2' @ort3 more t3an exclusions or deductions !a At FIG tax rate* H"II exclusion or deduction 2orth HFI !b At FIG tax rate* H"II credit 2orth H"II* because credits come after application of the tax rate; !c Can be refunda*le to those in the IG tax bracket* so they actually AET HH !d <on8t hinge on marginal rates* so they have a uniform effects on TPs* unlike deductions and exclusions* 2hich really matter more at the margins;
S-00 exclusion S-00 deduction S-00 credit Tax+a,er A 90U tax Dorth HFI Dorth HFI Dorth H"II TP B 29U tax Dorth H+F Dorth H+F Dorth H"II TP % 0U tax Dorth HI Dorth HI Dorth HI if not refundable Dorth H"II if refundable

!a

>' Earned Income Tax %redit !a =perates as a federal 2age subsidy to single or married TP* 2ith or 2Cout kids !b 1ot available to TP 2ith more than H+I? or H+E? in investments; !c Maxes out at H00II !for a t2o parent#family 2ith t2o or more kids making H""? a year in earned income ; !d Jargest anti#poverty program the government runs; !e in)le 18t1o (ids! !i Income at or above H$F;$?* HI EITC !ii <ecreases after H"0;0?##H$F;+ income !iii Plateau from H""? to H"0;0? !iv Peak at H""? income !H00II EITC

!v Must be earning income to get the EITC !vi A single person 2ith t2o children therefore has no federal tax liability 2hen they earn less than H"0;%?- HF? deduction and H/;%? credit; !f "arried 18t1o (ids don8t pay taxes if combined income less than H++;.? %3ild Tax %redit! !a H"III for each )ualifying child under 6+0!c !under "E* dependent* name and ((1 !b Phases out at higher levels of income under 6+0!d !c Incenti0es! better characteri9ed as relief to those 2ith children than an incentive to have children; >ut if you are on the margins of having earned income for not* then you are incentived to push to get more earned income !d Jargest federal child relief program* more than +;F times 2hat 2e provide through TA1&; !e Aood for the middle class7
U Eli)i*le for %3ild Tax %red I;+ "0;0 +%;+ +E;E +E;0 $";. $F +/;/ 3are of %3ild Tax %redit I;" 0;F "0;0 "0;% "";E +0;% "F;. "0;+

Income Ran)e \H"I? H"I#+I? H+I#$I? H$I#0I? H0I#FI? HFI#EF? HEF#"II? H"II#+II?

%' "ixed Personal and Business Deductions " Remem*er &eneral Rules $E" EME !a The general rule under 6+%+ is that personal deductions usually are not allo2ed !i >ut 6+"$ and 6"%F!e !$ and anything that carve out personal exemptions trumps this; !b The general rule under 6"%+ is that the expenses of carrying on a trade or business are deductible !i 6%E7 +G floor on itemi9ed deductions7 this means that the deductions must exceed +G of ad:usted gross income to be deductible !and are only deductible to the extent they exceed +G of AAI ; !ii 6%.7 The threshold is currently H"II? AI for an unmarried person; People 2Cincomes above H"II? must reduce their other2ise allo2able deduction by either7 $G of the excess of AAI over H"II? =@ .IG of other2ise allo2able itemi9ed deduction !iii This general 6"%+ is not an itemi9ed deduction- it8s included in 6%+* ho2ever the 3if you are an EE4 exception !2hich allo2s deductions for different stuff is an itemi9ed deduction !c Acti0ities not for +rofit 4-H>! allo2s a deduction for activities not done for profit* up to the gross income of the activity that is engaged in not for profit2 !i This is an itemi9ed deduction- TP sub:ect to 66"%+ or +"+ are not sub:ect to this deduction; !ii <oes not alter deductions for expenses that are deductible 2Cout regard to 2hether the activity is personal; 6".$!b !" ;* so only comes into play if gross profits are greater than those deductions;
T,+e of Ex+ense Is it deducti*le Is it itemi5ed #imits on deducti*ilit,

!" TradeCbusiness expense of non#EE !+ TradeCbusiness expense of EE !$ Production of income not tradeCbusiness !0 Activity not engaged in for profit

Oes* bCc of 6"%+ Oes under 6"%+ Oes under 6+"+ Oes under 6".$

1o* bCc of 6%+ 1o under 6%+ Oes under 6%+ Oes under 6%+

1one ]] !not really +G floor under 6%Ead:usted gross income phaseout under 6%. +G floor under 6%Ead:usted gross income phaseout under 6%. <eductible to extent of income from activity under 6".$- +G floor under 6%Ead:usted gross income phaseout under 6%.

!F Personal

1o under 6+%+

2' $o**, or BusinessB !a Nic(erson 02 %ommissioner !p; 0I$ !i &ACT(7 TP bought a dairy farm- I@( says it 2as used for leisure rather than for profit; TP gre2 up on a farm but 2ent into advertising* then at age 0I branched out and tried to make the farm productive* and incurred losses in doing so; TP 2as trying to say he 2as in @o2 !" on the above chart as to the farm7 business expense of a non#EE; I@( says it 2as @o2 !0 ; This 2ould mean that his expenses 2ould only be deductible as to his income from the farm and could not offset his advertising :ob income; !ii H=J<I1A7 they expected to make a profit* so it 2as a tradeCbusiness expense; &he legal test is %hether &' has a sincere !rofit motive for engaging in the activity; !iii <=@A17 this is not a realistic test; !b 4-H>.d' says that an activity that is profitable in $ out of F consecutive years is presumed to be engaged in for profit; !i Even if it doesn8t meet this test* TP can sho2 profit motive for tradeCbusinessCfor profit treatment using nine factors in @eg; 6";".$#"!c ; $EE EME; !c @3itten 02 %ommissioner !p; 0+F !i &ACT(7 TP appeared on Dheel of &ortune and had net 2innings; TP 2ants to deduct the expenses of appearing on the sho2; !ii H=J<I1A7 6"%F!d does not allo2 a deduction* it limits it; 6"%F!c only allo2s loss deduction if they are entered into for a trade or business or casualty loss; !iii <=@A17 He 2ould have had to prove that he fit @o2 !" in order to prevail here* because other2ise he the losses 2ouldn8t have made it into the +G floor any2ay; $ Personal Ex+enses in t3e Office $enderson 02 %ommissioner !p; 0+/ !a &ACT(7 TP buys a plant* framed picture* and parking space at her office for decorating her office; !b H=J<I1A7 Those are personal expenses* they don8t affect trade or business; If buying a plant for your office isn8t a personal expense* nothing is; C' $ome offices !a 6+.IA7 TP can deduct home office expenses if self#employed* but not if :ust someone else8s EE 2ho 2orks at home; !i 6+.I!c !" is the filter7 TP must have a trade or business under 6"%+ to )ualify for this deduction !production of income* hobby doesn8t count

!ii 6+.IA!c !F limitation on deductions; (o7 $ome office ex+ense! Income from trade or business use of home minus Ppersonal expenses other2ise deductible !like mortgage and real estate tax plus business expenses not attributable to the business use of the homeQ; The result is 2hat TP may deduct for home office expenses; Dhat you get to deduct under 6+.IA is basically 2hat you haven8t been able to deduct yet; !b Po+o0 02 %ommissioner p; 0"0 !i &ACT(7 TP shares a " bedroom apartment 2ith her husband and child; (he is a chamber orchestra and symphony musician; (he practices her instrument in the living room; TP claims her living room is her principle place of business; !ii H=J<I1A7 TP gets the deduction- the test is from Commissioner v; (oliman* and involves the relative importance of the activities performed at each business location and the time spent at each business location to determine the primary place of business; Here the first test is inconclusive* because practicing and performing are both integral to her :ob- but the second part really 2eighs in favor of the living room being the principle place of business; 9' Deducti*le Business Tri+ or %om+ensationB !a Rudol+3 02 /nited tates p; 0$$ !i &ACT(7 An insurance company provided a trip for its agents and their 2ives to 1OC; !ii H=J<I1A7 The trip is taxable on the full value5it has to be all or nothing; It is both income for services and personal expenses; The court says it can8t be a personal and business trip and deduct some but not all; He 2as not an 3entrapped organi9ation man*4 as there 2as no compulsion to go on the trip* so it doesn8t get out of income or personal expense on a 3convenience4 or re)uirement of E@ argument; !iii <=@A17 As in >enaglia the fairest outcome 2ould be to figure out the actual value of the trip to the TP and then only tax him on that amount; >ut this is tax la2 so fair don8t matter too much; !b Dan0ille Pl,1ood 02 /nited tates p; 00$ !i &ACT(7 The TP corporation tried to claim business deductions for sending invitees of customers to 1e2 =rleans for (uper >o2l Deekend; !ii H=J<I1A7 to be deductible as a business expense* must be ordinary and necessary to the business- the 6"%+ test is if it is directly related to or directly proceeds from the business; They never even get to 6+E0; (o the E@ can8t deduct the costs associate 2ith sending the EEs that 2ent* but this doesn8t doesn8t mean those EEs can deduct the cost of 2hat they spent there- so the court says it 2as compensation to them and taxable to them; !iii <=@A17 the E@ should get the deduction for sending the EEs* since it 2as taxed to the EEs as compensation; !c &ifts to %lients! TP may take a business deduction for the first H+F per year of untaxed gifts made to each client; 6+E0!b !" ; This generally :ust applies to small gifts given to customers to bolster good2ill; !d +ouses! for a business expense for an EE8s spouse to be deductible no2adays* the spouse also has to be an EE of the same E@ and there must be a good business reason to send the spouse; 6+E0!m !$ ;

6' Deductions for Tra0elD EntertainmentD Food .a' &eneral Rules !i Entertainment expenses associated 2Cbusiness and directly precede or follo2 a substantial and bona fide business discussion deductible under 6+E0!a !" !A ; <ues or fees to a club only deductible to the extent the TP ACT'AJJO uses it primarily for business purposes; 6+E0!a !+ ; 1= dues that are 3membership dues4 in a club organi9ed for business* pleasure* recreation* or other social purpose are ever deductible; 6+E0!a !$ ; !ii Tra0el expenses deductible if they directly relate to or directly precede or follo2 a substantial and bona fide business discussion* including meetings; 6+E0!a !" !A ; Forei)n tra0el! you have to separate the business costs from the personal benefits and can only deduct the business purpose costs 2hen the travel is out of the country; 6+E0!m !$ ; =nly deductible if it is reasonable for the meeting to be held outside 1orth America; 6+E0!h !" ; !b Onl, 90U of an, of t3ese costs are deducti*le *, ER 42=C.n'! removes half the food* beverage* entertainment deduction; This 2as a later amendment; =nce TP passes 6"%+ primary business purpose and 6+E0 direct relation to trade or business tests* TP still loses half of the deduction for food* beverages* or entertainment; .c' #unc3es for EEs !i "oss 02 %ommissioner !00I &ACT(7 TP is a partner in a la2 firm* everyone in the firm meets each 2orkday for lunch at a reasonably priced restaurant for a lunch meeting; Dants to deduct the price of the lunches; H=J<I1A7 the lunch costs 2ere not deductible- there is no sho2ing that there needed to be lunch everyday AT the restaurant for them to get their business done; Josing under 6"%+; It8s an inappropriate subsidy for people 2ho are able to combine personal consumption and business 2hen many can8t and those are often lo2er income; <=@A17 =f course there is a personal component* but that8s al2ays true 2ith business lunch5it8s food; To mitigate this result* the firm should serve lunch in the office and tell EEs that they all have to be there; This 2ill get it in under 6""/ bCc it is on premises and for the convenience of the E@; EE8s 2on8t include as compensation* E@ can deduct; !ii To avoid inclusion in EEs income* lunches should be provided on the premises and mandatory for the convenienceCnecessity of E@ !d Extra0a)ance! no deduction for lavish or extravagant foodCbeverages; 6+E0!k ;; =f course 3business related4 first class travel and nice hotels are not extravagant; !e Exce+tions! see 6+E0!e and !f * e;g; E@ can deduct items covered by a reimbursement arrangement; !f u*stantiation ReEuirements! not that interesting no2* but used to be key 6+E0!d ; =' %ommutin)

!a (pecial rule in 6"%+!a !+ says travel expenses a2ay from home and meals are deductible; !i 3Home4 may not mean real home* but location of business; !ii Exam+les! TP lives in Areen2ich but 2orks in 1OC* traveling from 1OC to Areen2ich each day; 1ot deductible* :ust commutingCpersonal under 6+%+; e;g; Flo1ers; TP above goes on a day trip for a photoshoot for her maga9ine- toCfrom the photoshoot is covered by the general rule of 6"%+!a ; The meals there may or may not be under the "oss primary purpose test; TP above goes to JA for t2o days for some consulting- travel and meals are both deductible under 6"%+!a !+ 8s special rule; !b %ommissioner 02 Flo1ers !0F/ !i &ACT(7 TP lives in ,ackson* hired by a la2 firm client in Mobile to go in house* but made arrangements to keep living in ,ackson; !ii H=J<I1A7 Travel from ,ackson to Mobile not deductible travel expenses; Three conditions must be satisfied before a travel expense deduction can be made under 6"%+!a !+ 7 P"Q reasonable and necessary traveling expense P+Q incurred a2ay from home P$Q incurred in the pursuit of business; !c $ant5is 02 %ommissioner !0%F !i &ACT(7 TP 2as a la2 student 2ho couldn8t get a :ob after her +nd year at a >oston firm* she and her H lived in >oston; Instead she a got a :ob in 1O; (he tried to deduct cost of travel as 2ell as the apartment she rented in 1OC; !ii H=J<I1A7 1ot deductible- her 3home4 for the purpose of 6"%+!a !+ 2as her place of employment; The dispositive thing 2as 3a2ay from home4 in the &lo2ers test; %3ildcare 0I% EME !a mit3 02 %ommissioner !0F% !i At the time of this decision* childcare costs 2ere not deductible 2hether or not the parents 2ere 2orking- children 2ere vie2ed as a personal expense; !b There is a line dra2ing problem7 2hy allo2 deductions for childcare but not commuting* or not for clothesB .c' %3ildcare deductions toda, !i Personal exemptions under 6"F" F Child Tax Credit under 6"+0 Above available to single or married TP 2ith children <o nothing to correct the 2ork disincentive
$F@ 1or( @ 1or(sD $ 3ome H"II? HFI? ame as tax $As im+uted income H"+I? H0I? ame as .-' deduction for S20; H"+I? HFI?

Tax rate L FIG* one child* childcare costs L H+I?Cyr HLH+I?Cyr D LH"II?Cyr
&ross income Net cas3 H"+I? H0I?

!ii Credit under 6+" for employment#related child and dependent care expenses !both parents have to 2ork to claim this ; Oou back bC2 +I#$FG of your employment#related childcare costs up to the cap; H$k cap for one child* H%? for t2o or more or if the actual cost is lo2er the income of the secondary spouse is the cap

'sing above numbers* TP can take the full H$? credit so H$? times +IG L H%II !there is a chart in 6+" about 2hat percentage of the credit you get at 2hat income level !iii Care assistance exclusion under 6"+/ 'sing above numbers* TP can take the HF? exclusion so HF? times FIG e)uals H+FII 'nder the above numbers* this means the exclusion is the better election as it usually is for higher income families; <isincentive7 TP only saves H+FII on childcare if both 2ork* but save H"I? if secondary earner :ust stays home; !iv TP can take both the exclusion and the credit5may run 2hatever is left from the credit through the exclusion; <' %lot3in) Ex+enses !a (ometimes deductible as a business expense if P"Q re)uired for 2ork P+Q not adaptable for general use P$Q not '(E< for general use !b Pe0sner 02 %ommissioner !0EF !i &ACT(7 TP 2anted to use a sub:ective test for above factors; (he 2orked at an haute couture store and had to 2ear their clothes at 2ork* but didn8t 2ant to or think she could 2ear them 2hen not at 2ork !too fancy and expensive for her taste and purposes ; !ii H=J<I1A7 The test has to be ob:ective- other2ise it 2ould be un# administrable and unfair- t2o people 2ith different taste and income 2ould have different deductibility for the same clothes; -0' Education Ex+enses !a %arroll 02 %ommissioner !0.0 !i &ACT(7 TP 2as a police officer 2ho 2as going to college to get a >A* 2anted to deduct the tuition as a business expense; !ii H=J<I1A7 1ot deductible- it 2ould only be appropriate to deduct education expenses 2hen maintaining or improving skills necessary to the :ob you already have; TP here 2anted to get the degree to go on to la2 school* so it didn8t pass the ob:ective test; .*' Ot3er Educational %redits !i H=PE Credit7 can only claim for t2o years* never after sophomore year* phases out for incomes bC2 H0+#F+ for singles and t2ice that for marrieds; Claimable by student or anyone 2ho can claim student as dependent; (tudent must be enrolled at least half#time in degree program; !ii Jifetime Jearning Credit7 up to H+? for post#secondary ed; 'nlimited years* same phaseout as H=PE* same people can claim as can claim H=PE* student can take as little as one course if improving :ob skills !need not be degree prog; !iii 1either credit is refundable5can8t get a check through it; =ne student can8t do both credits together; .c' Ot3er Educational Deductions !i 4222 deduction for post#secondary ed; H0? cap if TP has up to H%F? income* or H+? cap if over H.I? income; 1ot itemi9ed; (ame re)uirements for claiming as credits; Can8t claim if claiming either credit; !ii Coverdell Education (avings Account under 6 F+/7 basically a tax#free savings account for anyone under ".; Amounts contributed not deductible* but accumulates tax free and distributions for ed; expenses not included in

gross income; H"?Cyr total contributions* can be used any level of ed; Phaseout of eligibility to use this at H/I#""I?; Can claim either credit in the same year you get a distribution from Coverdell as long as don8t count same ed; expenditures t2ice; !iii Vualified Tuition Program under 6F+/7 must be sponsored by state or ed; institution; 1o income limits on 2ho can contribute- can8t exceed amount ot be used for ed; expenses; Aro2thCdist; for ed; expenses not taxed; Can claim either credit in same year as getting distribution from this* and getting distribution from Coverdell* as long as no ed; expense claimed more than once;
Pro0ision $o+e #ifetime learnin) # In Ded Ed Ex+ %o0erdell tate Tuition T,+e of +reference 1@ credit H"FIICyr 34 H+IIICyr <eduction up to H+FIICyr H0III deduction Tax#free ins buildup R Excludable distribution 33 Income limits HF+?#"IF? 34 H%F?#"$I? H.I?#H"II? H""I?#++I? 1CA %ost to / HF;$ billionCyr 2ith belo2 HF;$ billionCyr 2ith above H" billionCyr H+;. billionCyr H"II million H.II million

.d' Polic, !i Dhy no :ust give a deduction for money TP puts into savings plan for edB That 2ould sho2 up 2ith cost to government today but giving same value at the back end doesn8t do that* making budget look more balanced than it is !ii Dho is benefitingB 1ominally students and parents @eal benefit to colleges and universities in higher tuition; --' #e)al Ex+enses !a /nited tates 02 &ilmore !0E. !i &ACT(7 TP tries to deduct legal expenses re7 divorce proceeding on the theory that if he8d lost the case* ex#2ife 2ould have taken much of his stock interest in the business he o2ns* and he 2ould have lost it; Therefore he says it is maintenance of income#producing property under 6+"+!+ ; !ii H=J<I1A7 This is not deductible as a business expense- the litigation does not arise from profit#seeking activities5the underlying claim is divorce 2hich is personal; The test for deductibility of legal expenses 2hich emerges is the origin of the claim test under 6+"+; !iii <=@A17 the standard under 6"%+ is the exact same standard5the only difference bC2 the t2o sections is the presence or absence of the trade or business; <oesn8t matter 2hether it8s trade or business or production of income and the test is the same 2hether TP is N or U;
Tax+a,er ?en Jay Je2is Jibby Tom <elay @afael Palmeiro >ill Clinton #e)al Ex+ense 1egotiating employment ?* criminal U for fraud InvestigationCindictedCtrial Money laundering Per:ury investigation Paula ,ones la2suit- impeachment Deducti*ilit, OE( OE( to all OE( OE( OE( to both

proceedings

The nature of each of these legal claims gre2 out of the TP8s professional capacity D' Deductions for t3e cost of earnin) income -' %a+ital Ex+enditures !a Definition of a ca+ital ex+enditure! any expenditure made to ac)uire an asset that has a useful life of more than one year2 In other 2ords7 !i If a business asset is spentCconsumed in one year* 2e allo2 a deduction for it !ii I& a business asset lasts and produces income for longer than a year* it is a capital expenditure !iii 1ot a precise definition !b Cannot be deducted currently !c Included in and made part of the basis of the asset* recovered 2hen TP starts to make subtractions in basis !depreciation* sale of property .d' @3at must *e ca+itali5ed !i 426>.a'.-' F .2'! any amount paid for ne2 buildings or improvements to increase the value of any property* or restorations to property or making good exhaustion of property* can8t be deducted; Must be capitali9ed; .ii' Exam+les of *u,in) a 0ine,ard to ma(e 1ine! Must be capitali9ed7 Jand >uilding E)uipment Arapes Dine Aood2ill of former o2ners May be deducted 'tilities EE (alaries =ffice supplies !e Enc,clo+edia Britannica 02 %ommissioner !0/" !i &ACT(7 TP* a publisher* paid another publisher to make a book* but contracted to hold the copyright and publish it themselves; Danted to deduct the entire price of the contract; !ii H=J<I1A7 1ot deductible* and that 2ould be an easy decision if the "Ith Circuit hadn8t given some contrary cases; The manuscript 2as an income# producing asset for more than one year and is therefore a capital expenditure; Expenses should be matched 2ith income so both 2ill happen over some years; !iii <=@A17 key language in this case is 3allocating expenditures among different books is not al2ays necessary !for matching;4 This allo2s Posner to distinguish the "Ith Circuit cases; This is both self#serving and incorrect 5he 2as an author producing steadilyT Exam+le! Dhen it costs TP H"II to 2rite a book and TP 2rites a book every year for $I years7
Oear " <eduction Oear + <eduction Oear $^; Oear $I Oear $"

Capitali9ationC<educt 2hen Income @eceived Current Expense !6"%+ <eduction 2hen paid

HI H"II

H"II !cost for book " H"II

H"II H"II

H"II H"II

H"II HI

Posner says they are the same* but they are not because the ability to deduct the H"II in Oear " rather than thirty years later is a big value; The longer the period the bigger the value to TP of the early deduction !and 2orse for the government ; !iv A background issue here is the difference in treatment bC2 internal and external expenses; Congress ultimately passed the 'niform Capitali9ation @ules under 6+%$A* to erase the difference in current deductibility bC2 internal and external costs of businesses !f Re0enue Rulin) H9:H2 !0/. !i &ACT(7 &armer did not deduct the costs of planting and raising crops* and then sold them to TP; The TPCpurchaser then harvested and sold the crops the year after the sale; TP 2anted to currently deduct the portion of the purchase price of the farmland attributable to gro2ing the crops; !ii @'JE7 Treasury @eg 6";%"#0!a says that farmers 2ho buy goods for resale must account for the cost of the goods 2hen the goods are sold and may deduct the cost of the items in the year purchased =1JO if the goods are also sold in that year; !iii H=J<I1A7 The TPCpurchaset must capitali9e the cost of the crops in the first year* but may take account of that capitali9ation 2hen the crops are sold the follo2ing year by amorti9ing the cost; .)' /niform %a+itali5ation Rules 426>A! Allocation of 13at is ca+itali5ed !i All allocable costs of ac)uiring the asset must be capitali9ed 6+%$A!a !" !ii Allocable costs include direct costs of the property and the property8s proper share of indirect costs; 6+%$A!a !+ !iii Capitali9ation rules apply to property produced by T= in#house or property ac)uired for resale !e;g; this 2ould apply to a book manuscript produced in# house ; 6+%$A!b Includes salaries of the people 2riting the manuscript Indirect expenses include allocable share of supervisory and administrative salaries also @etailers are excluded if their gross receipts are less than H"IM; 6+%$A!b !+ !> ; !iv There is an exception for farmers in 6+%$A!d - the definition of farming business is in 6+%$A!e !0 ; !v The Encyclopedia >ritannica decision is no2 codified* defining production as construct* build* install* manufacture* develop* or improve; 6+%$A!g ; !vi The regulations carry this rule farther All costs of manufacturing inventoryCgoods to be sold* including items like insurance on the manufacturing plant* must be added to the cost of inventory and deducted 2hen inventory is sold Costs that <= 1=T need capitali9ation include marketing* advertising* and general and administrative expenses not related to sale or production !h INDOP%O 02 %ommissioner !FI"

&ACT(7 TP incurred investment banking fees in connection 2Ca merger 2Canother firm; 1o separate or identifiable asset had been created to 2hich the outlays could be allocated* so the TP deducted the banking fees as a current expense; !ii H=J<I1A7 The Commissioner 2ins- the banking fees must be capitali9ed; Although the mere presence of an incidental future benefit may not 2arrant capitali9ation* a TP8s reali9ation of benefits beyond the year in 2hich the expenditure is incurred is very important !i;e; if the benefits of a cost 2ould not be reali9ed until future years* the cost must be capitali9ed; !iii P@=&7 The 3future benefits4 rubric is very broad and not that helpful; The rules might leave the TP 2ith a capitali9ed item !like banking fees 2ithout a determinable of finite useful life* so that there is no amorti9ation or depreciation deduction; 2' Re+airs 02 Im+ro0ements !a There is a cra9y distinction- repairs deductible under 6"%+* 2hile replacements or improvements must be capitali9ed; 1o bright line rule so highly litigated; !i Re+air! doesn8t add value or prolong life of property* :ust keeps it in good operating condition over useful life !ii Re+lacement! substitution* materially increases value or increases life* usefulness* strength* capacity of property; !Problem is that any good repair does thisT !b "idland Em+ire p; FI+ !i &ACT(7 TP had oil leaking into the basement of his meat packing business; Meat inspectors said he had to fix it in order to keep the business open; He put concrete lining in the basement and that 2as successful; The TP deducted the expense as an ordinary business expense under 6"%+!a ; !ii H=J<I1A7 basement 2asn8t enlarged* 2asn8t made more attractive or stronger* and :ust brought basement back to the position !Kalue#2ise 2here it 2as before the oil started leaking; 1ot improved relative to its position before the problem arose; !c Re0enue Rulin) <C:>H !FI% !i &ACT(7 TP8s business discharges ha9ardous 2aste- to comply 2ith government regulations* the TP elects to remove the 2aste from the soil surrounding its property; Effect of the remediation 2as to restore TP8s land to the condition it 2as in prior to the contamination; The TP then 2anted to deduct the costs incurred to clean the land and treat the ground2ater that TP had contaminated; !ii TE(T7 Compare the status of the asset after the expenditure 2ith the status of the asset before the condition arose that necessitated the expenditure; If the value of the property is increased bC2 these t2o points* then it is a capital expense; !iii H=J<I1A7 Here the soil remediation and ground2ater treatment 2ere ordinary and necessary business expenses* so deductible; The ground2ater treatment facilities constructed by the TP* ho2ever* increase the value of the property and have a useful life* so they must be capitali9ed; !d Nor1est %or+oration and u*sidiaries 02 %ommissioner !F"" !i &ACT(7 TP 2as a bank* 2hich renovated its building in the process of taking out asbestos; TP said the renovation 2as necessary* a repair* and therefore deductible; TP only deducted the part attributable to the asbestos*

!i

conceding the rest of the renovation 2as improvement and should be capitali9ed; !ii H=J<I1A7 1o deduction at all* capital expenditure even for the asbestos removal; It is too hard to separate it from the larger pro:ectCgeneral plan of rehab* even if it 2ould have been a repair if it 2as the only thing done;
Annual depreciation deduction >aseline HEM for 2hole pro:ect renovation R asbestoscapitali9e @enovation alone HFMcapitali9e H+$$?Cyr After#tax value of depreciation allo2ances H""E?Cyr Present#value to year one H";.M After#tax cost of pro:ect in year one HEM # H";.M L HF;+M HFM # H";$M L H$;EM

H"%E?Cyr

H.$?Cyr

H";$M

!iii <=@A17 There is a H";FM after taxCH$M before tax difference* suggesting that TP 2ill do the pro:ects separately if the asbestos removal costs less than H$M; >' &ood1ill and ot3er assets !a @elc3 02 $el0erin) !F+F !i &ACT(7 TP 2as employed by a co; that 2ent bankrupt and found a ne2 :ob* then paid off some of the debts of the old co; in order to enhance his o2n standing in the business community and cultivate customer relationships; He 2anted to deduct those payments under 6"%+ as ordinaryCnecessary business expense; !ii H=J<I1A7 The cost of good2ill is not deductible* so no deduction allo2ed here; The payments are akin to the capital ac)uisition of good2ill; 3=rdinary4 means that* from experience* 2e kno2 that the payments are common and accepted in the general community- it doesn8t have to do 2ith regularity* :ust commonality; People don8t ordinarily in the normal course of business pay the debts of others; !iii <=@A17 This case doesn8t tell us that much- the book calls it pompous; !b $istorical Pro*lem! Aood2ill 2as considered to have an indefinite life2 Oou buy assets 2ith a useful life* but there 2as no definite time for depreciation deduction for an intangible; !c %on)ressional Res+onse! 6"/E gives people an arbitrary "F year period to amorti9e good2ill* but only good2ill that is purchased not any that TP creates internally; !d 426>A allo2s for deduction of some things that might be considered 3intangible4 like marketing* selling* advertising; .e' Education Ex+enses t3at relate to +roduction of income !i =b:ective test is to rely on the distinction bC2 capital expenditures and current expenses !ii 1= deduction allo2ed for the expense of meeting minimum education re)uirements for )ualification of a :ob !iii 1= deduction for expense of program being pursued by someone 2hich 2ill lead to )ualifying in a ne2 trade or business !iv There are TD= MAI1 overlapping categories of !income producing education deductions Education that maintains or improves skills re)uired by individual in his employment or other tradeCbusiness

Education that meets the re)uirements of the individual8s employer or re)uirements of applicable regulations as a condition of retention of the EE C' Rent Pa,ment 02 Installment Purc3ase !a tarrAs Estate !F+" !i &ACT(7 sprinkler co; leased a sprinkler system to TP- lease payment 2as the same for five years* and then rene2able after that for nominal amount; TP treats the payments as deductible rent but I@( says it is an installment sale; If it is a sale* then the sprinkler co; should be able to include the difference bC2 basis and amount they received- if it is a lease* the full amount of the lease payment is income to them; !ii H=J<I1A7 It is obvious that this 2as a sale since the sprinkler system 2as tailored to TP8s building- the nominal payments in years F#"I represented :ust maintenance feesC !iii <=@A17 The Court notes that cases like this are not profitable for the I@(but <oran thinks the I@( is not seeing the full picture of the transaction; The production cost of the sprinklers 2as H0?- the sale price 2as HF?- the depreciation calendar is +I years* and there is a pretty big different bC2 choosing purchasing a sprinkler for H"+IICyr for F years or leasing it for H"+IICyr for F years !2hen both include a nominal fee for subse)uent maintenance ; Exam+le!
eller Deal A7 buy a sprinkler* pay H"+IICyr for F years A@H%? A>H0? H+? <epreciation !H"+FI Interest !H"III !H++FI (o under deal A there is a net #H+FI tax* and under deal > a net #H"III? tax; Deal B7 rent a sprinkler at H"+IICyr for F years @ental incomeH%? <epreciation !H"? HF? @ent deduction!H%?

Bu,er

In0entor, Accountin) !F". !a Rationale! There is a need to match income 2Cexpenses !i 1ot feasible to keep track of ho2 much TP paid for each item in its inventory 2hen holding a large volume of goods ac)uired at different times !ii &ross Profit e)uals gross receipts minus costs of goods sold; !iii Pro*lem is determining the price of goods sold !b In0entor, Accountin) definition !i %ost of )oods sold 6 value of inventory at start of year plus ne2 purchases made during the year minus value of the inventory at the end of the year; Exam+le! retailer sells coffee mugs; Oear I buys "III for H"ICeach and sells /II for H"FCeach; Oear + buys "III at H"0Ceach and sells "III for H+ICeach; Oear "7 H"I? minus H"? L H/? !cost of items sold ; H"$;F !gross receipts minus H/? L H0;F gross profits; FIFO "et3od !&irst in* first out Exam+le from a*o0e

a; Oear +7 beginning inventory L H"? !left over from year " ; 1e2 purchases L H"0?; 'nder this accounting method* the "II left over at the end of Oear + are considered to be out of the ones bought in Oear +- so the value of ending inventory is H"0II; (o cost of goods sold is H"? plus H"0? minus H"0II L H"$;%?; #IFO "et3od !Jast in* first out Exam+le from a*o0e a; Oear +7 beginning inventory L H"? !left over from year " ; 'nder this accounting method* all of the mugs sold in Oear + are considered to be sold first so the value of ending inventory is H"? !2hat 2as left over from year one ; (o cost of goods sold is H"? plus H"0? minus H"? L H"0?; !ii <ifference in taxes paid is 2hether JI&= or &I&= is used; Must pick one method and stick 2Cit through course of business; Aenerally JI&= better if TP expects prices to rise; 6' Deducta*ilit, of #e)al Fees8Ille)al Profits !a &illiam 02 %ommissioner p; F$I !i &ACT(7 TP is on a plane on a business trip from <C to Memphis- he takes <almane pills and they make him go cra9y on a flight attendant and a fe2 passengers; He is arrested for assault and battery upon landing and put on trial; TP 2ants to deduct his legal fees for the civil and criminal trials resulting from this case; !ii H=J<I1A7 1o deduction; Even though it occurred during business travel* the going cra9y and assaults 2ere not ordinary business expenses; The three prong test of 6"%+!a is not satisfied7 ordinary* necessary* in connection 2Ctrade or business; !iii <=@A17 TP cites <ancer on pp; F$0#F$F* 2here the TP 2as driving on a business trip and caused an accident; There the theory 2as that people driving often cause car accidents* 2hereas here going cra9y on an airplane is not typical of traveling by air; At first it seems that the 3ordinary4 distinction doesn8t actually do much 2ork here* but the Ailliam TP 2as pleading temporary insanity in his trials and that is pretty clearly personal and not business related; .*' Ille)al or /net3ical Acti0ities !i te+3ens 02 %ommissioner p; F0I &ACT(7 TP embe99led from his company- sentenced to five years in prison 2Canother five years suspended if he makes restitution of H"M to the company; TP claims a deduction under 6"%F!c !+ as a loss* allo2ing TP to deduct expenses related to a transaction not made as part of a trade or business that 2as for profit; The Commissioner claims the deduction 2as a frustration of public policy and should not be allo2ed; H=J<I1A7 deduction granted; This is restitution and not a fine* and the public policy exception to 6"%F is limited in the same 2ay 6"%+!c !f M!g are limited to 2hat they say- there is nothing in there about not deduction restitution payments; !ii (tatutory deduction disallo2ances 6"%+!c !" disallo2s deduction of any bribe or kickback paid to a government official

6"%+!c !+ disallo2s deduction of any bribe or kickback that 2ould sub:ect TP to criminal prosecution 6"%+!c !$ special rules for bribes* rebates for MedicareCMedicaid 6"%+!f 7 no deduction of any fine or penalty paid to federal or state government for violation of any la2; 6"%+!g 7 no deduction for +C$ of the amount paid for treble damages for violation of antitrust la2s Kery narro2 =' Reasona*le %om+ensation !a 4-62.a'.-' provides a deduction of 3reasonable allo2ance for salaries or other compensation for personal services actually rendered4 !i =riginally intended to permit TP to deduct reasonable amounts for salaries even if not paid !ii 1=D relied on by I@( for denying deductions for unreasonable salaries* usually 2hen it is a sham salary and is really a nondeductible dividend Di0idends 02 %om+ensation Compensation is for services rendered- <ividends are to share profits 2Cstockholders Tax +olic,! both are income to the payee* but only compensation is deductible by the corporation paying it; a; Corporations have an incentive to pay !or treat money as compensation rather than dividends; b; If an EE o2ns "IIG of a company !or a substantial share it makes sense to treat as much income as compensation as revenue to maximi9e the deductions bC2 the t2o parties Typically* the I@( sides 2ith the TP on these )uestions as long as the company isn8t too greedy !b 4-62.m'! publicly held corporations !i;e; 2ere management and o2nership are not the same cannot deduct more than H"MCyear to pay the CE= and the other four highest paid officers of the corporation; !i This limitation does not apply to commissions or performance#based compensation or attainment of performance goals determined by the board of directors; !ii <=@A17 There is no real logical tax policy for the numerical limit* it8s :ust a 2ay to protect shareholders from a too#co9y CE=C>oard of <irectors relationship; >ut it only helps shareholders if you assume a2ay the problem it is trying to solveT It penali9es shareholders5the CE=s 2ill still demand more than H"M The company can8t deduct the payment over H"M* so the co; loses .c' &olden Parac3ute Rule 442H0.)'D C<<< !i A company loses deductions from a golden parachute payment if it is deemed excessive; !ii The recipient of the golden parachute is sub:ect to an additional +IG excuse tax on such payments E' De+reciation and t3e In0estment %redit -' De+reciation &enerall, !a TP gets a deduction each year for anticipated decline in the value of the property on the theory that there should be an offset against revenues for the cost of a

2asting asset that has a life beyond the current year that is used for the production of revenue; !i 6"%E!a deals 2Cdepreciation of property that is used in a trade or business or for the production of income; The idea is if the TP invests in property for income production* TP can deduct the yearly decrease in value due to 2ear and tear* etc; T= essentially recovers basis over the useful like !b Exam+le! TP pays H"I? for machine; <educts H+? depreciation per year; At year E* sells for H"II; !i =riginal basis 2ould be H"I? under 6"I"+ !ii Ad:usted basis under 6"I"%!a !+ !ad:ustment 2ould be H"I?* because he took H+? depreciation deductions for F years* the maximum time he could do so 2ould be H"I? # H"I? L HI; !iii (o gainCloss is H"II gain; HI minus H"II; .c' Buildin) Bloc(s of De+reciation !i <etermination of useful life !ii Accounting for salvage value !iii Application of a method of allocating costs in excess of salvage value over the useful life; !d >asis is reduced as long as TP had the option to take a depreciation deduction* even if they didn8t take the deduction; .e' Reca+ture Rule !i Aain in the disposition of personal property is treated as ordinary income to the extent of prior deductions for depreciation; 6"+0F; !ii Aain on the disposition of real property is the excess of accelerated depreciation over straightline depreciation if ac)uired before "/.%* or :ust straightline depreciation if ac)uired after "/.%; 2' T3eor, 02 Realit, !a T3eor,! depreciation is a limited exception to the reali9ation re)uirement !i If TP invests in property as part of trade or business* TP can deduct the yearly value that comes from yearly do2ngrading of the property rather than 2aiting for a reali9ation event to recogni9e !b Realit,! more complex- depreciation deductions are allo2ed at a much faster rate of return that actual deterioration of items; !i This is on purpose* to encourage investment !ii Accountin) met3ods that allo2 larger deductions in earlier years lead to even greater frontloaded depreciation deductions Exam+le! machine 2C cost basis of H"II? and a useful life of F years trai)3t #ine !cost basis divided by useful life a; Oear "7 <epreciation H+I?* Ad:usted >asis H.I? b; Oear +7 <epreciation H+I?* Ad:usted >asis H%I? c; Oear $7 <epreciation H+I?* Ad:usted >asis H0I? d; Oear 07 <epreciation H+I?* Ad:usted >asis H+I? e; Oear F7 <epreciation H+I?* Ad:usted >asis HI Declinin) *alance met3od! straight line percentage is determined and then increased by a specified factor- the resulting percentage is applied to the cost of the asset reduced by the amounts previously

deducted; Dhen the straight line deduction exceeds the declining balances amount* TP s2itches to straight line; Dou*le declinin) *alance met3od !t2ice ad:usted basis divided by recovery period then s2itch to straight line 2hen favorable a; Oear "7 <epreciation H0I? !H"II? times + divided by F * Ad:usted >asis H%I? b; Oear +7 <epreciation H+0?* Ad:usted >asis H$%? c; Oear $7 <epreciation H"0;0?* Ad:usted >asis H+";%? d; Oear 07 <epreciation H"I;.? !s2itching to straight line because more favorable7 H+";% !current basis divided by + !years of useful life * Ad:usted >asis H"I;.? e; Oear F7 <epreciation H"I;.?* Ad:usted >asis H"I;.? Income Forecast7 current year8s depreciation deduction is derived from a pro:ection of future income >' Basic Rules !a Reco0er, Period for most goods is the useful life* determined in 6"%.!e !i There are % classes of personal property !ii &or real property* the recovery periods are +E;F years for residential and $/ years for non#residential property !b An individual 2ho gets more than one asset in a single transaction must allocate a portion of the purchase price to each asset on the basis of the &MK of each asset at the date of purchase !i i;e; the purchase of a business is seen as the purchase of all the different parts of the business .c' "et3ods for different t,+es of assets .i' Personal Pro+ert, <ouble#declining balance for $*F*E*"I year property ";F <eclining >alance Method for "F* +I year property &irst year7 rate is half of 2hat it 2ould be for the full year unless the asset 2as ac)uired in the last )uarter of the first year and )ualifies for a mid#)uarter convention4 &or the last year* a half#year8s deduction is allo2ed .ii' Real Pro+ert, (traightline method is the basic method &or the first and last years* a full deduction is prorated according to the number of months during the year that the property 2as in service Component depreciation is not permitted; !iii Reca+ture Rules are complicated 1ot eligible for the installment method The amount of recaptured gain reduces the amount of deduction in the case of a gift of property to charity !iv Intan)i*le assets are sub:ect to 6"%E and must use the straightline method -9 ,ear amorti5ation of intan)i*le assets 4-<= Aood2ill Aoing concern value Kalue of in#place 2orkforce Kalue of current relationship 2ith customersCsupplier

 PatentsCcopyright &ilms* sound recordings V' TAM AVOIDAN%E A Estate of Fran(lin 02 %ommissioner p; F%% CHI@EJ(TEI1 "$;I" p; "+$ EME example .%!c ; " &ACT(7 a group of physicians formed a partnership* entered into a purported sale to purchase a hotel from the @omneys; Partners buy the hotel for HEF? and H";+M non# recourse "I#year note !debt secured by the hotel upon 2hich they 2ill make H/? monthly payments to the @omneys; Then they lease the hotel back to the @omneys* 2ho pay them H/? monthly rent; Therefore no money actually changes hands monthly* it is a 2ash cash#2ise and tax#2ise; TP claim deduction for the interest payments of H/? and depreciation deductions; + H=J<I1A7 This is a sham* no one may take deductions; The disparity bC2 the &MK of the property and the amount of the debt is the ma:or kicker; $ <=@A17 The fact that the land and motel 2ere only 2orth H%II? made the H";+M mortgage look fishy from the get#go; The point of the scam 2as this7 any amount a TP pays in nonrecourse debt to ac)uire property becomes part of the basis* so the basis is inflated to H";+M from 2hich they partners could calculate depreciation deductions; The plan 2as to not pay off the debt after ten years and allo2 the hotel o2nership to revert back to the @omneys; !a $,+o! Dhat if they had cut everything in half* so that the nonrecourse debt 2as for the &MK of the property !H%II? and the cash payment 2as H$E;F?B !i This 2ould be a sale of the depreciation deductions !ii Congress enacted a safe harbor for leasing that 2ould allo2 this type of transaction > @inn Dixie 02 %ommissioner !FE. " &ACT(7 TP purchased company#o2ned life insurance !C=JI for its EEs 2CTP as the sole beneficiary; TP borro2ed against the policies8 account values at a rate of more than ""G 2hich out2eighed the net cash surrender value and benefits of the profits; The idea 2as to lose pre#tax money on the program; The I@( assessed a deficiency bCc there 2as no business purpose or economic benefit to the program; + I(('E7 If a tax scheme follo2s the letter of the la2* is the sham transaction doctrine still applicableB $ H=J<I1A7 There 2as no benefit to the TP or its EEs other than the tax preference* so the deduction is denied; A transaction is not entitled to tax respect if it lacks economic effects of substance other than the generation of tax benefits* or if the transaction serves no business purpose; %' ;nesc3 " &ACT(7 TP bought "I $I#year deferred annuity bonds each 2orth H0II? 2ith stipulated to gro2 in value at +;FGCyear; He paid H0*II0*III* 2ith the H0k in cash and the H0M nonrecourse debt at an interest rate of $;FG; He pays the first year8s interest on the note immediately !H"0I? then borro2s H//? and again prepays the first year8s interest !H$*0%F ; If TP didn8t do the borro2ing* he8d be getting annuity payments of about H/I?Cmonth- instead* he gets only H0$Cmonth; + H=J<I1A7 This is a sham- there is no real indebtedness and no money#making :ustification other than the tax deductions; 1othing substantial; $ <=@A17 'nlike &ranklin this case is ade)uately secured; The outcome might be a little harsh* 2hich is 2hy Congress stepped in; .a' afe $ar*or #easin) .re!ealed shortly after institution'

D'

E'

F'

&'

Congressional scheme to let companies that couldn8t get the benefit of the ne2 depreciation schedule to get (=ME benefit Essentially a Congressionally#sponsored tax shelter !ii Basic sc3eme! A company 2Cno taxable income could sell an asset to another company 2ith taxable income Jeaseback 2ould give company A use of the asset Company > 2ould get the depreciation deductions Passi0e Acti0it, #osses and %redits " 4C6<.a'.-' disallo2s passive activity losses and passive activity credits + A Passi0e Acti0it, under 4C6<.c'.6' is conduct of any trade or business in 2hich TP does not materially participate* including 6+"+ activities !a generally material +artici+ation is regular and substantial activity 60%/!h !b 60%/!g !" 2hen TP finally disposes of their interest in the passive activity* TP can take advantage of the full loss associated 2ith it !the intent is to create a rule that defers 2hat Congress believes are non#economic losses $ A Passi0e Acti0it, #oss under 4C6<.d' is the excess from aggregated losses of all PA activities minus al aggregate income from PA !a TP must 3basket4 all losses against all income from P( !b Cannot be used to offset regular income !c A disallo2ed loss or credit may be carried for2ard to the next year and treated as allocable to the same activity in the next year 60%/!h !+ At Ris( #oss #imitations 4C69 " &or certain activities* your loss from that activity can be deducted only to the extent that you or the company is 3at risk-4 but those losses can be carried for2ard and run through the rules each year until deducted; 60%F!a ; + Amounts considered at ris( under 60%F!b 7 !a Amount of money and the ad:usted basis of other property contributed by the TP to the activity !b Amounts borro2ed re7 such activity !c May include &MK of a security recourse debt !d <=E( 1=T include non#recourse debt if financed by a third party $ A++lica*le Acti0ities under 60%F!c !a Production of films and videotapes !b &arming !c Jeasing of 6"+0F property !d Exploring for or exploiting oil and gas !e Exploring for geothermal deposits !f And any activity for production of income after "/E. !this kind of means everything 0 Exam+le! TP buys a H+M motion picture* but only pays H+II? in cash for it* and the rest 2ith non#recourse debt* TP can only deduct H+II? in losses if the 2hole thing turns out to not make any money on release; #imitations on Deductions of Interest on in0estment inde*tedness 4-6>.d' " @estrict deductions of interest on debt tied to any investment like stocks* bonds* and real estate + Amount allo2ed as a deduction for investment interest shall not exceed the net investment income of TP for the year "odern %or+orate Tax 3elter Re)ulation

!i

" +

Congress unable to I< the common denominator about abusive transactions themselves 1e2 rules go after accounting firms selling tax shelters !a Tax 3elter Promoter Penalt, 6%EII7 penalty for anyone making a false or fraudulent statement !i @aised from "IG to FIG of gross income derived from producing a shelter !b 6%""" a material advisor of a reportable transaction must file an info return describing the transaction and its benefits and 6 %""+ compile a list of clients advised on the transaction !i material advisor L la2yer or accountant !ii @eportable transaction L high tax avoidance or evasion potential !iii Penalty for not filing HFI#+II? on a corporation* H"I?#H"II? on an individual !iv H"I?Cday penalty 2ith no cap for not providing client list !v Ja2 firms tried to litigate this as a confidentiality issue and failed !vi 1o statute of limitations Accurac, and Fraud Penalties! aimed at substance of TP8s legal arguments
%ode 6%%%+ Penalt, +IG of underpayment Defense @easonable cause and good faith !unsophisticated TP 2ho 2as confused 2hen advised @easonable cause and good faith- substantial authority- reasonable basis and disclosure to I@( @easonable case and disclosure and substantial authority and reasonable belief that more likely than not !all four factors necessary for defense @easonable cause and good faith

Reason for Penalt, 1egligenceCdisregard for rules and regs (ubstantial understatement of tax 'nderstatement from reportable transaction

6%%%+

+IG of underpayment

6%%%+!a

+IG of underpayment* $IG if no disclosure on return

'nderpayment from fraud

6%%%$

EFG

u*stantial Aut3orit,! someone has to tell you that you 2ill have at least 0IG chance of success on the merits before the Tax Court !b Reasona*le Basis !<=@A1 calls it the chuckle test 7 if you can say it 2ith a straight face* then it usually passes !c These are :udged on an ob:ective standard $' Policin) " This is a self#assessment system 2here TP are supposed to police themselves and comply + Penalties are 2hat 2ill really affect behavior* so if its behavior for 2hich there is no possible penalty >' Role of #a1,ers !a Advise clients 2here they stand !b Maximum penalty is disbarment !c Ethical rules7 !i (ame ethical rules as everybody else* plus special I@( rules

!a

!ii tax layer can8t advise client to take a position unless there8s a realistic possibility of success on the merits !" in $ chance of 2inning in litigation 0 Circular +$I !pp; F0I#F0+ 7 .a' VI'IN%O"E ATTRIB/TION A' Alternati0e "inimum Tax -' @3ere did it come fromB !a Didespread perception that tax system unfair !b =riginal idea 2as that higher income TP 2ould calculate their interests both 2ays and pay at least some tax !c 1o2 applies to millions of Americans though it 2as not supposed to- reaches the middle class !d It is basically an attack on preferences; Individual preferences include7 !i Tax#exempt interest !ii Percentage depletion !iii Intangible drilling costs !iv Itemi9ed deductions !see belo2 !v Credits 2' $o1 does it 1or(B !a 6FF!a tentative minimum tax minus the regular tax L AMT !i Tentati0e minimum tax L taxable income 2ith ad:ustments re)uired by 66F%* FE* M F. !this is the alternative minimum taxable income * minus exemption amount allo2ed to everyone times !this is the taxable excess times +%#+.G Taxable excess _ H"EF?* multiply by +.G Taxable excess \ H"EF?* multiply by +%G Taxa*le Excess L Alternative minimum taxable income minus exemption amount .*' Deductions NOT allo1ed !i Miscellaneous itemi9ed !ii (tate and local property taxes !iii Medical expenses above E;F#"IG !iv Certain home mortgage interest !v (tandard deduction !vi Personal exemptions !kids* etc !c (lo2er depreciation schedule for some property !d Jose some net operating losses* some tax exempt interest added back >' @3at is t3e +ro*lemB !a The exemption amounts not indexed for inflationCcost of living !b 1ature of items considered tax preferences* e;g; children !c <isallo2ing standard and itemi9ed deductions means that a lot of basic costs of the middle class aren8t going to save TP from AMT !d >ush tax cuts7 made a bad situation 2orse re7 AMT !i Most cuts that 2ent to the middle class 2ere taken back 2ith the expanded applicability of the AMT; !ii Affect concentrated in the middle class because at very high incomes you 32ealth out4 of the AMT !iii This 2as very deliberateallo2ed an across the board tax cut 2Cout losing much revenue

;laasen 0D %ommissioner !F/" !a &ACT(7 TPs have "I dependent children* and they 2ere sub:ect to the AMT because of the number of exemptions for their children; A family 2ith the same income but only . children 2ould not pay the AMT; They paid regular taxes instead* and the I@( assessed a deficiency; The TP said the AMT 2as contrary to Congressional intent as applied* and as applied violated the free exercise* e)ual protection* andCor due process clauses of the '( Constitution; !b H=J<I1A7 The statute is unambiguous- if Congress had not meant to reach this family* they 2ould have drafter it differently; It is up to Congress to fix the problem* not the courts; The fact that a generally applicable la2 may make the observance of some religious beliefs !like having a billion kids more expensive does not render the statute unconstitutional5there must be intentional discrimination* not :ust discriminatory effect; F Prosman 02 %ommissioner !F/F !a &ACT(7 TP8s E@ included TP8s travel reimbursement per diem as part of his 2ages instead of as a non#taxable reimbursement; The I@( issued a deficiency for failure to calculate the AMT; TP appealed* saying that if the E@ had separated the expenses* he 2ould not be liable for the AMT; !b H=J<I1A7 The AMT may be unfair* but the I@C is unambiguous and the AMT applies; TP could have negotiated a different employment contract if he did not 2ant to be sub:ect to the AMT; % Berman Article! see Table $ for possible solutions2 The President8s Tax Advisory >oard has a proposal for reform that calls for elimination of the AMT but spreads out the costs by reducing andCor eliminating certain tax preferences en:oyed by the middle class; B' Assi)nment of Income " @ules at first came from the Court* not Congress* to protect progressive rate structure .a' Ar)uments for +ro)ressi0e rate structure !i Tax should be measured by ability to pay7 one limitation of this is that if it8s the real ob:ective* should be taxing 2ealth and not income !ii People 2ith more money value random dollars less7 limitation is that you can8t measure actual happiness levelsCsignificance of money to them !iii Implicates a 2orkCleisure trade#off7 for additional increments of 2ork* steepness of rate structure 2ill affect the choice of 2hether to 2ork for that extra money or :ust spend time on recreation !b There have al2ays been attempts to shift income from people in higher brackets to people in lo2er brackets !relatives* etc .c' ummar, !i Aenerally income is taxed to person 2ho receives it !ii Assignment of income doctrine is an anti#abuse rule* an exception to the general rule above* to preserve the progressive rate structure !iii &irst prong7 Assignments of income from services generally not valid for tax shifting unless assignment is involuntary Assignments of income !roducing !ro!erty generally are valid for tax shifting purposes unless the transferor retains a reversion interest in the property !iv (econd prongB

!v Assignments of income from property created by services may or may not be valid- it depends on ho2 strong the property interest is; 2' Assi)nments of Income and %ommunit, Pro+ert, !a #ucas 02 Earl !%I" !i &ACT(7 H and D in California have a prenup in 2hich they consider all income they both ac)uire during and before marriage as community property; They divide income in half and file separately each claiming half of his 2ages; !ii H=J<I1A7 a valid state contract does not have this affect for tax purposes; !iii <=@A17 Interesting that the contract 2as entered into before there 2as a federal income tax* so the ob:ective of the contract 2as not tax avoidance; !b Poe 02 ea*orn !%I0 !i &ACT(7 (imilar to Earl* except in Dashington state 2here the la2 designates most property as community property; !ii H=J<I1A7 separate taxation is permissible- here the money has al2ays belonged half to the 2ife by operation of state la2- in Earl the money 2as al2ays originally the H8s but he gave half to the 2ife through a contract; !iii <=@A17 This is a dumb distinction* in neither case did the H have a right to half the money bCc it had been assigned many years ago* by contract or by operation of state la2; !iv A&TE@MATH7 This case 2as important in the development of marriage tax la2s This case gave marrieds in community property states a huge advantage Marrieds in other states 2ere mad "/0. Congress decided to treat all married couples as though they 2ere individuals 2ho took in half of 2hat the total couple had taken in during the year This created a marriage bonus7 giving each member of the couple a start at the bottom of the progressive rates structure 2Chalf the couple8s HH (ingle individual 2C the same income as a 2hole married couple only got one start at the bottom @ich singles got upset* especially some 2omen 2ho said they couldn8t find husbands because of all the DDII deaths Congress scaled back the tax burden on singles* so no2 there is sometimes a marriage penalty too The progressive rate structure re)uires this Oou can8t have a single person making H"II? be taxed the same as a single person making HFI? !see notes p; "I% Can8t have a progressives structure* treat all married people the same* and get rid of the bonusCpenalty >' Im+ossi*ilit,8Ille)alit, of TP Recei0in) Income !a First ecurit, Ban( of /ta3 !%"$* notes case !i &ACT(7 =ne TP 2as the holding co;* then there 2as a bank and a life insurance co o2nerd by the TP; The bank 2as selling life insurance* under2ritten by the life insurance co; The I@( said that part of the premium that goes to the life insurance co; should be taxed to the bank; !ii H=J<I1A7 1o* it is illegal for the bank to receive insurance commissions* so since they are not receiving them they should not be taxed for them;

C' Assi)nment of Income to ;ids !a Armantrout 02 %ommissioner !%"I !i &ACT(7 E@ makes a fund to pay for college tuition of key EE8s children; &orfeits of EE leaves employment before kid starts college; If kids don8t go to college* funds can be rolled over to next child- if no kids go to college* also forfeited; EEs 2ith no children get no part of this and no alternative; !ii H=J<I1A7 The amounts are taxable to the EEs; This is an anticipatory assignment of income- Earl stands for the prospect that the tax should be on the person the income can be attributed to; >y continuing to be employed* EEs have allo2ed a portion of their earnings to be attributed to their children* as though the EEs made a contract 2ith the E@ for the college fund; !iii <=@A17 in reality this seems a far cry from the type of assignment in Earl* esp; bCc no difference in the salaries of those 2ho did and did not benefit from the college fund; <oesn8t seem like direct compensation for services; !b Tesc3ner !%"0* notes case !i &ACT(7 TP entered into a contest even though only people under "E could 2in; He designated his daughter !under "E to receive the 2innings for both his entries; !ii H=J<I1A7 TP never had the right to the pri9e money under the rules* so he can8t be taxed on the income; <ifference 2CArmantrout 2as there the EEs could have bargained for a higher salary instead of the college fund* but here the contest rules 2ere firm; !iii <=@A17 choicesCvoluntariness seems to be the main factor* except here 2here it actually could have gone either 2ay5bCc TP could have chosen not to enter the contest; !c Blair 02 %ommissioner !%". !i &ACT(7 &ather assigned his rights to benefit from part of a testamentary trust to his kids !taking his o2n right to receive money during his life and giving slices of it to his kids ; !ii H=J<I1A7 the kids are taxable for the monies* bCc father actually fully divested himself of that portion of the money; Dhat he transferred 2as actually property that generated income; !d $el0erin) 02 $orst !%+I !i &ACT(7 TP gave coupon bonds !2here they give you the bond and some coupons to turn in for interest payments to his son; T= kept the bonds but gave his son the coupons; !ii H=J<I1A7 TP !dad is taxable on the interest income; This is a gift :ust of the income* not the income#generating property as in >lair; !iii <=@A17 if an interest in trust is property under >lair* 2hy isn8t a coupon on a bond property alsoB The different coupons* and the principal* are each generating income individually; The piece being held by the father increases in value as time goes by* and the same is true of the coupons held by the son;
%ou+on %ou+on 2 %ou+on > Princi+al At Issue HE0;IE H%.;F/ H%$;F" HE/$;.$ Gear H.I HE0;IE H%.;F/ H.FE;$0 Gear 2 H.I HE0;IE H/+F;/$ Gear >

H.I H"III

The decision is based on a 3battle of paradigms4; In Taft there 2as no )uestion that the recipient 2ould be taxed on the income from a gift* but Jucas said of 2hat you are transferring is not property the transferor 2ill be taxed on the income; (o the court is dra2n to that model and asks 2hether there is a transfer of income or property; !e %urrent ?uestion! though Horst and >lair are still both good la2* the )uestion is no2 %hether %hat has been transferred is the right to all or !art of the income from the !ro!erty %ith no reversion to the transferor# or a right to all or !art of the income from the !ro!erty %ith a reversion to the transferor/ 9' Assi)nment of income attri*uta*le to +ro+ert, created t3rou)3 ser0ices !a $el0erin) 02 Eu*an( !%+% !i &ACT(7 an insurance agent assigned back several rene2al commissions to his insurance company at retirement so he could get the income over several years instead of one; He assigned it to a trust that 2ould pay to his children; !ii H=J<I1A7 TP 2as assigning future income streams* so he is taxable on it in the present year; Horst controls; The income has already been earned even if not recieved* unlike in Earl 2here it had not; !b $eim 02 Fit5+atric( !%+E !i &ACT(7 TP had a series of patents that he assigned to a company that 2as o2ned by his immediate family and income from the patents 2as paid to the company and divided among the o2ners; The patents are sub:ect to a contract 2hich TP is free to cancel if royalties 2eren8t paid* etc; It is out of that holdback that he is making an assignment to his 2ife and kids; !ii H=J<I1A7 The rights TP assigns are substantial enough to constitute property* so the income is taxable to 2ife and kids not TP; He is transferring income producing property interest* not :ust income; It is not :ust a royalty stream that he has assigned- there is bargaining po2er* etc; Aoverned by >lair; VII' %APITA# &AIN AND #O E A' Four 1a,s %on)ress +references t,+es of income 18tax " Exclude something from gross income !6""/ + Allo2 a deduction !6"EI $ Allo2 a tax credit !6+0 0- "m!ose ta at a lo%er rate on certain classes of income1 this is the current a!!roach %2ca!ital gains .a' %urrent Rates Preference %a+ital &ains 4-.3'
Ordinar, Income Rates .U' #on) Term %a+ital &ain Rates 3ort:Term %a+ital &ain Rates &ain on real estate 3eld more t3an one ,ear to t3e extent of de+reciation +F +F +F +F "F "I &ain on collecti*les 3eld more t3an one ,ear +. +. +. +F "F "I &ain on certain small *usiness stoc( after 90U exclusion +. +. +. +F "F "I

$F $$ +. +F "F "I

"F "F "F "F F F

$F $$ +. +F "F "I

!i @ight no2 long term capital gains rate is preferential for everyone !ii (hort term capital gains rate preferential for no one

!iii Aains held on real estate preferential for those at or above +.G income bracket !iv Aains on collectibles preferential for those at or above $$G income bracket !b Dis+reference for %a+ital #osses! can be netted out against capital gains* but can only offset H$? of ordinary income in a year; Corporations can8t deduct A1O capital loss; !i Ordinar, losses and ca+ital )ain! ordinary losses can offset any kind of gain* including capital gain; (ee notes p; ""$ for examples; B' @3at is u+ 1it3 t3e ca+ital )ain and loss re)imeB " There are strong feelings on both sides of the issue + Congress is al2ays changing the 2ay they are taxed !a bC2 "/.% and +II. Congress has been at both extremes !b Preference eliminated in "/.% !c In +II. some people 2ill get a IG taxation bracket on long term CA >' Ar)uments FOR %& +references !a Jock#in effect !i TP 2ho hold appreciated assets reluctant to sell them bCc of the tax on gains >ad for flo2 of capital* reduces li)uidity Aovernment benefits by raising some tax instead of none if people never sold anything !ii %ounter ar)! The step#up in basis at death is a bigger lock#in issue- TP likely to be responsive to the fact that if they hold an asset until death* no one 2ill pay tax on it; !iii Jock#in does distinguish bC2 assets people hold for investment and those they hold for sale in the ordinary course of business; It 2ould make sense to have no capital gain treatment for people in the business of selling things bCc they 2ill sell them any2ay !b Corporate double tax at corporate and then shareholder level; !i Counter#arg7 capital gains rate applies to all capital assets* not :ust shares of stock- other2ise this argument 2ould be more compelling for encouraging movement of the stock market; 0 Ar)uments A&AIN T %& +references7 !a a dollar of capital gains is the same dollar as one coming from a trade or business; !b CA taxation too complex !c >enefits tend to go to those at higher end of the distribution level 9' Polic, of %# Dis+reference !a Prevents TPs from cherrypicking losses !i @eali9ation is in TPs control- they 2ould :ust reali9e losses and not gain if they could !ii Example7 TP makes H"M investment 2it FICFI chance of H+F? gain or loss* then enters into a transaction that perfectly hedges the first; DCno loss limitation* TP is unchanged financially but 2ould li)uidate the loss and hold the gain investment* reali9ing a big loss and no gain %' Net %a+ital &ains and #osses " Net %a+ital &ain is net long term capital gain minus net short term capital loss !see chart for more detail ; 6"+++!"" ; !a Net #on) Term %a+ital &ain or #oss! Excess of long term capital gain minus long term capital loss; 6"+++!E

Jong term capital gain L gain from selling or exchanging a capital asset held for more than a year if and to the extent the gain taken into account in computing gross income !that is* it must be recogni9ed and reali9ed ; 6"+++!$ !ii Jong term capital loss L loss from selling or exchanging a capital asset held for more than a year if and to the extent the loss taken into account in computing gross income 6"+++!B ; !b Net 3ort Term %a+ital &ain or #oss! amount of short term capital gains minus short term capital losses if negative; 6"+++!% + @3at is a ca+ital assetB 6 "++" omet3in) t3at is +ro+ert, *ut NOT7 !a stock in trade of TP* !b inventory of the TP !things TP is selling in ordinary course of business !c property sub:ect to deprecation under 6"%E !that used in a trade or business .i' Exce+tion t3at s1allo1s t3is rule A 6"+$" gain is a gain from sale or exchange of depreciable or real property held for more than a year used in trade or business but not for sale to customers in ordinary course of business 6"+$"!b If 6"+$" gains exceed 6"+$" losses* they are treated as long#term capital gains and losses; If these losses exceed gains* treated as ordinary; 6"+$"!a !" ; Al2ays good for the TP !d self#created IP !e accounts receivable !f notes receivable >' T3is is t3e seEuence !a Jong Term Capital Aains and Josses7 2here capital assets has been held for more than one year !i 6"++$ has special rules for determining holding period of property Includes time during 2hich TP holds asset (ometimes includes time other than 2hen property held* or time 2hen another person held it 6"++$!/ 7 holding period of property from a dead person includes the time they held it5step up holding period if there is appreciation after death* beneficiary automatically deemed to hold asset for more than one year !is this different from aboveB !b (hort Term Capital Aains and Josses7 2here capital asset has been held for less than a year; !c 1et Jong Term Capital Aains against Jong Term Capital Josses !d 1et (hort Term Capital Aains against (hort Term Capital Josses !6"+++ separates long and short term and nets them separately
TP 3as Net #on) Term %a+ital &ain TP 3as Net 3ort Term %a+ital #oss !" if the long term gain is greater* the excess of the net long term capital gain minus short term loss 2ill be taxed at preferential rate long term capital gain rate !+ If short term loss is greater* the loss 2ill eat up the gain and if there is still loss after the H$? of ordinary income* you can TP 3as Net 3ort Term %a+ital &ain Jong term gain gets preferential rates and short term gain gets the non#preferential rates;

!i

TP 3as Net #on) Term %a+ital #oss

carry the short term loss for2ard The losses are deductible against H$? of ordinary income and the unused parts carried for2ard; The short term is used up first against the H$? of ordinary income;

!" If more gain than loss* the excess 2ill be treated as short term gain meaning no preferential treatment5ordinary rate !+ If more loss than gain* the loss 2ill eat up the gain* the next H$? can eat up ordinary income* and the rest can be carried for2ard as long#term capital loss for the next year

< Bielfeldt 02 %ommissioner !%E" " &ACT7 TP 2anted to offset his trading losses- he 2as betting on treasury bonds* buying them in large )uantities from deals in order to re#sell 2hen there 2as a shortage; He got burned* and 2anted to characteri9e his losses as ordinary !giving him a refund of H.FM instead of offsetting only H$?Cyr of ordinary income ; + TP A@A(7 He is a dealer* not a trader; A dealer buys and sells for someone else8s account and therefore stocks and bonds are their inventory* 2hich is not a capital asset under 6"++"; $ H=J<I1A7 TP a trader- clearly doing it for himself; The stocks and bonds 2ere property he 2as buying and hoping to sell himself; He makes no money off providing the service to others* he is :ust a private speculator; These are capital assets; 0 <=@A17 big problem here is there is no real definition of capital asset that 2orks; E Bieden3arn Realt, %o2 02 /nited tates !%EF " &ACT(7 TP 2as a corporation that bought a plantation as an investment; Eventually they improved it and sold off parcels for subdivisions; I@( said the income they got from such sales 2ere ordinary; + TP A@A(7 they are capital gains* bCc the original intent of purchase 2as an investment and they are :ust li)uidating an investment; $ H=J<I1A7 The TP clearly engaged in the sales as a part of its trade or business- the intent to invest had already been abandoned; There are a variety of factors to consider re7 2hether income 2as from investment or tradeCbusiness7 !a &re)uency and number of sales !b (ignificance of improvements !c (olicitation and advertising efforts !d >rokerage activities !e Importance of the activity in relation to TP8s other activities 0 <=@A17 some investments you hold 2ill go up* some 2ill go do2n; The TP can easily find himself on both sides of the arguments in these situations; & %orn Products Refinin) %o2 02 %ommissioner !%.F " &ACT(7 TP 2as in the business of producing corn products; It had problems storing enough corn to meet demand* so started buying corn futures to avoid spot market fluctuations; + 1=TE( =1 &'T'@E(7 !a &utures contract is entered into today 2ith a promise to buy at a specified date at a specified price; Protect against increase in price* but not decrease !i Example7 TP sells product for H+II bushel* contracts to buy corn gutures for ,an; " delivery at H"IICbushel; =n ,anuary " corn sells at H"FICbushel on the spot market; TP could

Take delivery* make a profit of H"II7 this 2ould be all ordinary income* from sale of inventory >uy on spot market and sell futures contract* make H"II profit7 this 2ould be half ordinary income from sale* half capital income bCc sale of the contract 2hich is a capital asset !courts says no to this $ H=J<I1A7 To hold that the income from sale of the futures contract is a CA 2ould allo2 those engaged in hedging transactions to transmute assets from CA to ordinary or viceCversa; The TP8s actions 2ere not those of an investor- they 2ere taken on :ust as a cheap substitute for storage facilities; &his doesn$t fit %2in the inventory e clusion# but to allo% 34 treatment %ould go against the 3ongressional !ur!ose; 0 <=@A17 Problem is that the court8s distinction is investmentCparty of everyday business; That interpretation exposed the I@( to a different 2hipsa27 if investment turned out 2ell* TP 2ould characteri9e it as separate from business therefore capital* and if it turned out badly* TP 2ould emphasi9e the business purpose; A Ar(ansas Best %or+ 02 %ommissioner !%./ " &ACT(7 TP bought more shares of a failing bank to help its business image; Jater it sold them as a loss; TP claims ordinary treatment on the theory that it held the stock as part of ordinary business operations; The Tax Court held that the sale of the stock purchased before the bank8s financial troubles 2ere investments and produced capital gains treatments* 2hile the sale of the stock purchased after the financial troubles produced ordinary income because the stock 2as bought for a business purpose5 preservation of good 2ill; + H=J<I1A7 TP 2as over#reading Corn Products- that case 2as actually :ust a broad reading of the inventory exclusion; There is no ordinary business transaction exception to the capital asset rule- unless TP is a dealer in stock or the stock is part of inventory* it is considered a capital asset; TP motivation is irrelevant as to 2hether the asset is property held by the TP; All of the TP8s stock 2as a capital asset and had to be treated as a capital loss $' %urrent Treatment of 3ed)in) transactions " A capital asset excludes a hedging transaction if the TP identifies it as a hedging transaction 2hen entering into it; 6"++"!a !E ; + If TP chooses ordinary treatment by marking it as a hedging transaction* it takes that hedging transaction out of the market to market rules !2hich make TP take account of gains and losses that have not been reali9ed 6"+F% ; $ The distinction bC2 capital and ordinary income is artificial- someone has to police the line and TP has to kno2 in advance 2hat kind of transaction they are entering into and that is problematic; I $ort 02 %ommissioner !%/F " &ACT(7 =ffice building left to TP after his father8s death; =ffice had a lease on it and a sublease- the rent 2as above market then; Tenant 2ants out and negotiates to pay H"0I? as consideration to cancel the lease; TP says this payment to him entitles him to a CJ on the theory that he 2as entitled to much more than H"0I? under the lease and the difference is capital loss; + H=J<I1A7 the H"0I? is ordinary income- TP 2as relin)uishing the right to the rest of the rent and simply got pre#payment of rent it agreed to be entitled to; @ent is ordinary income; $ <=@A17 this seems like the 2rong results; If TP8s dad had died 2hen the office building8s &MK 2as H$II? and the son sold it for H$EF? he 2ould get HEF? capital gain; If he had collected H+F? rent per year instead of selling* it 2ould have been

ordinary income; (elling all the rents at one time by selling the building is capitalgetting rent or selling the right to collect rent is ordinary; The different treatment seems 2eird; Arguably the :ustification is that there is an arbitrary distinction any2ay* and in a middle case like this it must go one 2ay or another; Classifying this as capital 2ould effectively collapse the distinction; 0 >=TT=M JI1E7 2here a TP is taking a stream of income that 2ould be ordinary if received in the stream but converted it to a lump sum that 2as :ust a substitute for the stream* it retains its character as ordinary income; "c%allister p; EI+ " &ACT(7 TP had a life interest in a trust 2Cremainder to another and converted the life interest; + H=J<I1A7 CA treatment 2orks here; >lair controls; &ransfer of income !roducing !ro!erty generally results in 34 treatment unless transferor retains reversion interest in the !ro!erty; (ame as assignment of income; %ommissioner 02 Bro1n !EI/ " &ACT7 1on#profit Cancer @esearch !C@ bought stock from TP8s lumber co; for H";$M; They dissolved the co; and leased the bi9 to ne2 company o2ned by TP8s la2yers* 2hich operates the bi9; The purchase price 2ill come from profits of ne2 co; and 2hen H";$M is paid* C@ 2ill o2n the lumber co; outright !bootstrap sale ; 1ote also secured by assets of the lumber business so TP 2ould recover it on default; + H=J<I1A7 This is CA !as TP 2ants ; If everything goes as planned in the transaction* there is no reversion right of TP5only default could result in reversion; &re)or, 02 $el0erin) !E0I " &ACT(7 TP o2ns "IIG of 'nited Mortgage 2hich has "III shares of Monitor (ecurities; (he sets up Averill Co; and transfers the "III Monitor shares to Averill as a tax#free reorgani9ation; Then she dissolves Averill and under li)uidation rules the "III shares revert to her in a tax#free exchange !2hy tax freeB Then she sells the shares and claims that the gain is CA; + H=J<I1A7 TP should be taxed as if 'nited Mortgage had sold the shares and paid her the dividends; Jegal hook is that the reorgani9ation has no business purposes; This is still good la27 any reorganization# in order to get ta -free treatment# must have a legitimate business !ur!ose inde!endent of any ta !ur!ose; @illiams 02 "c&o1an !E0$ " &ACT(7 TP o2ned a business 2Ca partner- 2hen the partner died TP bought out his interest and became sole o2ner; TP then sold the bi9 and claimed ordinary treatment of the loss on the theory that it 2as lots of inventory he 2as selling; + H=J<I1A7 Dhen TP sold the business he 2as sole proprietor* and 2as selling assets and liabilities* and those must be taken piece by piece for distinction bC2 capital and ordinary treatment; (till good la2; !a (elling off stock is disposition of capital assets even if a partnership !b (ale of business assets must be item by item "erc3ants National Ban( 02 %ommissioner !E0% " &ACT7 >ankCTP 2as holding notes and sold to a $rd party* reported the gain as CA; + H=J<I1A7 These 2ere ordinary gains >ECA'(E the TP had already claimed an ordinary loss on the notes in an earlier year; $ <=@A17 This is like a recapture or tax benefit analysis; 6""" doesn8t get you far bCc it doesn8t tell you about character of lossCrecovery; There is no real recovery herethings turned out in a 2ay the TP did not expect; If anything drove the outcome* it 2as the TP changing its characteri9ation mid2ay through;

= Arro1smit3 02 %ommissioner !E0% " &ACT(7 TP li)uidated a co; over 0 years* properly claiming CA treatments on the distributions; Jater there 2as a :udgment against the no#longer#existing co; and TP had to pay the :udgment; TP claimed an ordinary deduction on the payment; + H=J<I1A7 The :udgment payment must be taken as CJ* as it is part of the original li)uidating transaction;