Income Tax Outline

When is it income?

Cash Method

Accrual Method

Claim of Right

Installment Sales

Like-Kind Exchange: Nonrecognition Provision

- Code Section: 1341

Involuntary Conversion (Pg. 976-77; 982-987)

- The notion in Like-Kind Exchange that is also applicable here is that the taxpayer, although
in possession of replacement property, has not changed her economic position. An
exchange of like kind properties is voluntary transaction.
o Section 1033 permits the non-recognition of gain in certain circumstances in which
property is involuntarily converted.
- Note: The involuntary conversion may be the result of destruction, theft, seizure,
requisition or condemnation or threat or imminence thereof.

The general message of Section 1033 can be simply stated: When property is involuntarily
converted into money, if the taxpayer so elects, gain is recognized only to the extent that the
amount realized as a result of the conversion exceeds the cost of the replacement property.

 The price of the nonrecognition ticket is that the replacement property must be “similar or
related in service of use” to the converted property and the replacement must occur within
the time limit of the statute.
o The provision does not apply to losses resulting from involuntary conversions and
generally does not apply if the property is acquired from a related person. The
related person restriction is not applicable to an individual taxpayer whose realized
gain does not exceed $100,000.
 Note: Be alert to correspond the basis adjustment resulting from
nonrecognition of gain.
 The basis for the replacement property is THE COST OF SUCH
PROPERTY REDUCED BY THE GAIN that is not recognized.
 Most of the controversy stemming from Section 1033 revolves around the
phrase “similar or related in service or use.”
CASES

Revenue Ruling 76-319 [Emphasis on “Similar or Related Services”]

 Bowling alley that was destroyed by a fire resulted in taxpayer receiving insurance
proceeds, The dude built a billard instead. Court ruled that that didn’t count in being similar
to a bowling alley.

Revenue Ruling 67-254 [Emphasis on “Similar or Related Services”]

 Land that got condemnation award was then taken to be used to be built as a building.
Court stated that it was in used for similar or related purposes and thus section 1033
applied.
- “Section 1033(a)[(2)](A) of the Code provides, in effect, that if property is compulsorily
or involuntarily converted into money and the taxpayer, during the period specified,
purchases other property similar or related in service or use to the property so converted,
at the election of the taxpayer the gain shall be recognized only to the extent that the amount
realized upon such conversion exceed the cost of such other property,”
o “… to the exten that the taxpayer expended the condemnation proceeds in restoring
the plantside so that it could be used in the same manner as it was used prior to the
condemnation, he has acquired property similar or related in service or use to the
property converted for the purposes…” of the specified section of the Code.

Revenue Ruling 71-41

 Whether the investment of condemnation proceeds qualifies for the nonrecognition of gain
provisions of section 1033 of the Code. Taxpayer owned land that he rent out to third
parties that got later condemned by the State. As such a gain was realized and the proceeds
were used to erected a gas station on the other land already owned by the taxpayer. He
rented the gas station out to an oil company. Question is whether the use of the
condemnation money can be qualified for a nonrecognition gain under 1033.
o The court says…
o “Section 1033(a) of the Cod eprovides, in part, that if property is, as a result of
condemnation, compulsorily or involuntarily converted into money and the
taxpayer during the period specified, purchases other property similar or related in
services or use to the property so converted, at the election of the taxpayer the gain
shall be recognized only to the extent that the amount realized upon such
conversion exceeds the cost of the replacement property.
 Section 1033(g) of the Code provides, in part, as follows:
 (1) Special rule—For purposes of subsection (a)m if real property
*** held for productive use in trade or business or for investment is
*** compulsorily or involuntarily converted, property of a like kind
to be held either for productive use in a trade or business or for
investment shall be treated as property similar or related in service
or use to the property so converted,
 “In considering whether replacement property acquired by an investor for
the purpose of leasing is similar in service or use to the converted property,
attention will be directed primarily to the similarity in the relationship of
the service or uses which the original and replacement properties have to
the taxpayer-owner.”
 In applying this test a determination will be made whether
properties are of similar service to the taxpayer, the nature of the
business risks connected with the properties, and what such
properties demand of the taxpayer in the way of management,
services, and relations to his tenants. Pg. 985
Capital Gains and Losses

In general, it is “capital gain” that may qualify for special tax treatment and “capital loss” that may
encounter special, restrictive, rules as to deduction. Thus, we must look at items qualitatively as
well as quantitatively, a process referred to as the “characterization” of income and deduction
items.

- Whether a gain or loss is subject to special treatment, as “capital” as opposed to “ordinary”,

usually is dependent upon
1. Whether it arises in a transaction involving a “capital asset”
2. Whether the capital asset has been the subject of a “sale or exchange,” and
3. Whether the taxpayer has “held” the asset for a sufficient period of time.
- Failure of a transaction to involve a capital asset or a sale or exchange results in ordinary
income or an ordinary deduction.
o However, one should be alert for statutory provisions that may artificially afccord
capital gain or loss treatment to some transaction which do not actually involve the
sale or exchange of a capital asset.

History of Capital Gains: It has always been clear that a merchant’s sale of stock in trade gives
rise to gain or loss to be taken into account for tax purposes. However, when the first income tax
was imposed following the adoption of the Sixteenth Amendment, it contained no specific
reference to gains or losses from dealing in property. What then of a sale of plant or equipment?
Of land held for investment? Of securities? And so forth. Taxpayers were prompted to argue that
gain on the sale of such properties was not income within the meaning of the Sixteenth Amendment
or the federal taxing statute. In part the thought was the if one sold, say, securities and merely
reinvested the proceeds in other securities (or even put the money in the bank), her financial
position was unaltered; she had merely substituted the new securities (or the cash) for the securities
previously owned and her investment continued. The notion was bolstered by the further thought
that if there was gain of some sort in such transactions it might be largely illusory anyway, often
traceable to mere changes in the price structure.

Merchants’ Loan & Trust Co. v Smietanka: The Supreme Court held that capital gains were income
within the meaning of that term in the Sixteenth Amendment. Relying in part on cases under the
Corporate Excise Tax Act of 1909, the Court, quoting its opinion in Eisner v. Macomber, said
“Income may be defined as the gain derived from capital, from labor, or from both combined,
provided it be understood to include profit gained through a sale or conversion of capital assets.

- While Merchants’ Loan was the end of the constitutional issue whether capital gains were
subject to tax, it marked only the beginning of congressional consideration of HOW such
gains should be taxed.
- In 1921, Congress enacted the first provisions giving preferential treatment to capital gains
by way of a tax rate on such gains below those applicable to other types of income.
Reporting the bill, the Ways and Means Committee said:
o “The sale of *** capital assets is now seriously retarded by the fact that gains and
profits earned over a series of years are under the present law taxed as a lump sum
(and the amount of surtax greatly enhanced thereby) in the year in which the profit
 is realized. Many such sales, with their possible profit taking and consequent
increase of the tax revenue, have been blocked by this feature of the present law. In
order to permit such transaction to go forward without fear of a prohibitive tax, the
proposed bill *** adds a new section *** [placing a preferential rate on gains from
the sale or dispositions of capital assets].
- While it may be argued that capital gain is no different in kind from other income and is,
perhaps just as spendable, three factors have now been identified that seem to give it a
different qualify. That is, a disposition of capital asset may involve only a continuation of
an investment
o Beginning ins 2013, while the 15% tax rate was retained for middle-class taxpayers,
for upper-income taxpayers, the rate returned to 20%

Capital Loss: The first limitation upon the deductibility of capital losses appeared in the Revenue
Act of 1924.

- “… But Congress failed to place a similar limitation on capital losses, so that to-day the
taxpayer pays a maximum tax of 12.5% on gains derived from the sale of capital assets,
but is allowed to deduct in full from his taxable income his net losses resulting from the
sale of capital assets during the taxable year.”
- “…By reason of this transaction he would pay, in addition to the tax on his regular income,
$12,500 to the Government. But assume that instead of selling this stock at a profit, he sold
it in 1922 at a loss of $100,000. He would then be entitled to deduct the $100,000 from his
income of $350,000, and the loss to the Government by reason of that deduction would be
$58,000. Is there any further argument needed?” Pg. 747

The Revenue Act of 1924 and successive acts have provided a limitation on the deductibility of
capital losses. Although changes have occurred, restrictions upon the deductibility of capital losses
have continued to the present. Without such limitations, taxpayers would be able without limit to
use cpital losses to wipe out ordinary income from other sources, creating a new type of tax shelter.

- Thus, taxpayers with the usual varied results in their investment portfolios could use capital
losses to shelter ordinary income and hold capital gains for a step-up in basis at death.
Seemingly to avoid such a result, even in years when no preference was accorded capital
gains, Congress retained the capital loss limitations which operate in a manner similar to
the Section 469 passive activity loss limitations.

Mechanics of Capital Gain

The Internal Revenue Code provides preferential tax treatment for “net capital gain” as defined by
Section 1222(11). The 1986 Act fixed a ceiling tax rate of 28% for such net capital gain.

- The current statue retains the characterization provisions of the prior law with the same
basic code structure, but it taxes most net capital gain at a 15 or 20 percent rate.
However, the Code substantially complicates the computation of tax on net capital gains by
creating several different classes of net capital gains and imposing a variety of rates on those
additional classes. Put simply, reading Section 1(h) in cold blood is excruciatingly difficult. To
avert student revolts, we have assigned only some parts of Section 1(h) and we have tried to present
the big picture without dealing with all possible alternatives.

1. The first step on the road to mastering the mechanics of capital gains under Section 1(g) is
a special statutory structure under Section 1222. That Section requires deciphering in order
to understand the mechanics of both capital gains and capital losses. Section 1222 provides
a statutory netting mechanism. Section 1222(1) through 1222(4) define short-term capital
gain, short-term capital loss, long term capital gain, and long-term capital loss,
respectively. Sectopm 1222(5) through 1222(8) then in essence provide for the netting of
short-term losses against short-term gains and long-term losses against long-term gains in
the following manner:
a. [ Short-term capital gain (1222(1)) ] – [ Short-term capital loss (1222(2)) ]
= Net-short-term capital gain or loss (Section 1222(5) and (6))
b. [ Long-term capital gain (1222(3)) ] – [ Long-term capital loss (1222(4)) ]
= Net-longterm capital gain or loss (Section 1222(7) and (8))

2. Next, the net shorts are netted against the net longs. If net gains exceed the net losses in
this final netting, we apply the rules discussed in this part. BUT… If net losses exceed net
gains, we apply the rules discussed in part C of this Chapter.
3. In the final netting process under Section 1222, net gains can arise in three situations:
a. FIRST: A net short-term gain in excess of a net long-term loss
b. SECOND: A net long-term gain in excess of a net short-term loss (the excess net
long-term gain in this situation is classified by Section 1222(11) as net capital gain;
and
c. THIRD: A combination of a new short-term gain and a net long-term gain (with the
net long-term gain again classified as Section 1222(11) net capital gain.)

The treasury takes some liberty with a literal reading of the statute in filtering the results of the
above final netting process into gross income on the income tax return (Schedule D of Form 1040).

- If taxpayers falls into one of the three types of final net situation above, only the net
amount of the gain is included in gross income.
o The procedure used on the income tax return and in practice varies from the strict
statutory formula which would require inclusion of all gain in gross income and
deduction of all losses. Although generally the variant procedure generates the
same amount of adjusted gross income.

EXAMPLE: Assume that in the current year, T, a single individual taxpayer has a long-term capital
gain (Section 1222(3)) of 30,000, a long-term capital loss (Section 1222(4)) of $10,000, and a
short-term capital loss (Section 1222(2) of $5,000. Assume T has other income, salary for example,
of $50,000. Statutorily, T’s gross income is $80,000 computed as follows:

- Salary $50,000
 - Long-term capital gain $30,000
- Gross income $80,000

However, on T’s income tax return on Schedule D, T will net T’s capital gains and losses and, as
a result, we say that T has gross income of $65,000 computed as follows:

- Salary $50,000
- Long-term capital gain $30,000
- Long-term capital loss -$10,000
- Net long-term capital gain $20,000
- Short-term capital gain $0
- Short-term capital loss -$5,000
- Net short-term capital loss -$5,000
- Net capital gain $15,000
- Gross income (after capital loss) $65,000

In carrying out this intial netting process under Section 1222(1)-(4), a one-year line as drawn
between short-and long-term gains and losses, with long0term requiring a more than one-year
holding period.

- If after shorts are netted against longs, there is a net short-term capital gain (either in excess
of a net long-term capital loss or in conjunction with a net long-term capital gain), the
amount of net short-term capital gain is taxed as ordinary income.
- If, however, there is a net long-term capital(either in excess of a net short-term capital loss
or in conjunction with a net short-term capital gain), some type of preferential treatment is
provided to the “net capital gain” which is defined by Section 1222(11) as the excess of
net long-term capital gain over net short-term capital loss. As a result, all of the assets
making up net capital gain must have been held more than one year.

Section 1222(h): If in a year a non-corporate taxpayer has a “net capital gain” Section 1(h) comes
into play. When Section 1(h) applies, net capital gains are treated as though they were the
last taxable income received (i.e., the top incremented amounts of taxable income). The
preferential treatment that section 1(h) accords to net capital gains can take a variety of forms
depending upon the type of asset involved, the holding period for the asset, and the taxpayer’s top
ordinary income tax bracket for the year.

 Section 1(h) begins by extracting a portion of a noncorporate taxpayer’s taxable income

and taxing it at ordinary income tax rates under Sections 1(a)-€. Generally, but not always,
this reduction will be an amount equal to the taxpayer’s taxable income less net capital
gains, leaving only net capital gain to be taxed at a variety of rates under the remainder of
Section 1(h).
 As a practical matter, most net capital gain will be taxed at a 15 or 20 percent rate and for
purposes of this “Fundamental” course one may want to assume that the 15 or 20 percent
rates and the 25 percent rate are the only Section 1(h) rates.
 o In fact, however, there are currently six different rates (28, 25, 20, 15, 10, and zero
percent) that can potentially apply under Section 1(h) and those different rates are
explained in detail below.

The 28 Percent Rate. A 28 percent rate is imposed on several types of net capital gains. The gain
from capital assets that are “collectibles”—things such as art work, antiques, gems, coins, stamps,
and …alcoholic beverages?! Are generally taxed at a 28 percent rate. In addition, any Section
1202 gain (a concept considered below) is taxed at the 28 percent rate, but only to the extent that
the Section 1202 gain is included in gross income.

The 25 Percent Rate. A 25 percent rate is generally imposed on “unrecaptured Section 1250 gain”
to the extent that such gain makes up net capital gain. This rate applies to gains on the sale of
depreciable real property, generally to the extent that depreciation previously has been allowed on
such property. This type of net capital gain is considered in detail in a later Chapter.

The 15 and 20 Percent Rate. A 15 percent rate is generally imposed on the gain on most long
term capital assets included in net capital gain (other than gains from collectibles, unrecaptured
Section 1250 gains, and Section 1202 gains). Thus the gain on stocks, bonds, investment land, and
other types of capital assets which is statutorily labelled as “adjusted net capital gain” is generally
taxed at a 15 percent rate. As the year 2012 came to a close and the U.S. economy was threatening
to go over a “fiscal cliff,” Congress worked out a compromise under which high-income taxpayers
reverted to the previous top tax rates on income. AS a result, such taxpayers pay a 20 percent rate
rather than a 15 percent rate on their adjusted net capital gain.

The Regular Sections 1(a)-1(2) 10 and 15 Percent Rates. As employed here, the 10 and 15
percent rates do not appear on the face of the statute, but they are hidden within the depths of the
language of the statue. Under the mechanics of Section 1(h)(1)(A) to the extent that net capital
gain would otherwise be taxed at either the 28 percent or the 25 percent rate and to the extent that
the taxpayer has inadequate ordinary income (including net short-term capital gain) to fill up the
amount of taxable income taxed at below a 25 percent rate, first the 25 percent gains and then the
28 percent gains are used to fill in the gaps. To the extent so used, they are taxed at 10 or 15 percent
effectively under Section 1(a)-(e).

The Zero Percent Rate. Congress draws some similar lines, and it feels that it is inappropriate to
tax at a 10 or 15 percent rate adjusted net capital gains that would otherwise be taxed at a 15 or 20
percent rate if the taxpayer has been in a 25 percent or higher rate bracket. As a result, to the extent
that adjusted net capital gains would otherwise fall into the 10 or 15 percent ordinary income rate
bracket, such gains are taxed at a zero percent rate (not taxed!). Any remaining adjusted net capital
gains are taxed at a 15 or 20 percent rate.

EXAMPLE: A few examples in some simple situations may help to demonstrate the Section 1(h)
consequences. Single Taxpayer has the following events occur in the current year when we assume
Single’s ordinary income is taxed at a flat 30 percent rate under Section 1(c). Single ordinary
income taxed at a flat 30 percent rate under Section 1(c): Single has $100,999 of ordinary income
and a $10,000 LTCF from the sale of stock. Thus, Single has a net capital gain of $10,000 under
Section 1222(11). Tracking the relevant parts of Section 1(h), the results are as follows:
 - Section 1(h)(A)(i): An assumed tax of 30% under Section 1(c) on $100,000 ($110,000 less
$10,000 equal)  $30,000
- Section 1(h)(1)(B):  0
- Section 1(h)(1)(c): 15% of $10,000 ($10,000 less 0)  $1,500
- Section 1(h)(1)(D), (E), and (F)  0
- Total Tax Liability  $30,000+$1,500 = $31,500

If the stock instead had been a collectible, the result would be as follows

- Section 1(h)(1)(A)(i):  $30,000

- Section 1(h)(B), (C), (D), and (E): 0
- Section 1(h)(1)F: 28% of $110,000 (taxable income) less $100,000 (The amount taxed
under Section 1(h)(1)(A)-(D)) = ($10,000)(.28)  $2,800
- Tax Liability  30,000+ 2,800 = 32,800

If Single has the same $100,000 of ordinary income and has both a $10,000 LTCF from the stock
and a $10,000 LTCF from a collectible, Single would have a $20,000 net capital gain under Section
1222(11) and a tax liability determined as follows:

- Section 1(h)(1)(A)(i) $30,000

- Section 1(h)(1)(B) 0
- Section 1(h)(1)(c): 15% of 10,000 $1,500
- Section 1(h)(1)(D) and €: 0
- Section 1(h)(1)(F): 28% of 10,000 $2,800
- Tax Liability $34,300

Returning to the first example, if Single instead had $400,00 of taxable income (but assume a flat
30 percent rate under Section 1(c)) and a $10,000 LTCF from the sale of stock, the result would
be as follows.

[Copy Problem here from Pg 754]

Netting Within Section 1(h). Recall that in the first Section 1222 step prior to entering the Section
1(h) thicket, Congress used a netting process. Congress also provides for netting under Section
1(h) but it takes a statutory trapeze artist to swing through the Code section to comprehend the
Congressional legislation. Well hidden within Section 1(h) are a variety of netting rules that
happily reach apro-taxpayer result. Under the Section 1(h) netting process, netting first occurs
within each rate classification. IF there are net losses within any classification they then wipe
out net gains that would otherwise be taxed at the highest rate or combination of rates under
the Section1(h)(1) rate schedule.

- For example, if Single, in the examples above has net losses from capital asset whose gains
would be taxed at a 15 or 20 percent rate, those net losses would first wipe out net 28%
gains, then net 25% gains, then net 20% gains, and then net 15% gains.

Section 1202. As an incentive to encourage non-corporate taxpayers to invest in startup

companies, Section 1202 was added to the Code. The provision allows a non-corporate
taxpayer an exclusion of 100 percent of the gain on “qualified small business stock” acquired
after Sept 27, 2010, and held for more than 5 years. That is right: There is no tax on the gain.
However, there are ceiling limitations on the amount of a shareholder’s Section 1202 gain. In
addition, the definition of qualified small business stock is technical. There are lower (50 to
75) percent exclusion for small business stock acquired in prior years.

The Mechanics of Capital Loss

The losses discussed here are only deductible losses. Under Section 1222(2) and (4_ the terms
short-term capital loss and long-term capital loss are defined to include only such losses as are
“taken into account in computing taxable income.” Before we can discuss the mechanics of
capital losses, we must therefore determine whether a loss is taken into account; that is, whether
the loss is deductible. In the case of individuals, the primary Code section that determines
whether a loss is deductible is Section 165(c), which should be reviewed. If a loss is deductible,
then the provisions currently under examination determine how and to what extent the
deduction may be utilized.

Capital losses are generally deductible only from or against capital gains. Capital losses,
whether long-term or short-term, offset capital gains, long-term, or short-term, dollar for dollar.
In the case of non-corporate taxpayer, however, capital losses in excess of capital gains can be
deducted from ordinary income, but only to a limited extent. Any capital loss balance
remaining after the excess is deducted is carried forward into succeeding taxable years,
retaining its original character as either long-term or short-term capital loss. This carryover
loss is applied against capital gains (and to a limited extent against ordinary income) in each
succeeding year until fully utilized.

The statutory mechanics of Section 1222, previously discussed in Part B of this Chapter,
require the taxpayer first to “net out” long-term transaction and short-term transaction, and
then to “net out” net longs against net shorts. Somewhat like the first step in the net gain
situations previously discussed, the netting process results in three-possible net loss situations.

1. There may be a net short-term loss that reduces or eliminates, dollar-for-dollar, the
amount of net long-term gain.
2. Likewise, there may be a net long-term loss which reduces or eliminates, dollar-for-
dollar, any net short-term gain.
3. Thirdly, there is the possibility that net losses in both short-term and long0term
categories.

- The double netting process, now familiar, presents a procedure under which capital losses
are always fully utilized in any year to the extent that there are capital gains for the year.
Implicit in all this is the previously discussed rationale for the continued dichotomy
between capital gain and ordinary income; capital gain has limitless capacity for being
offset by capital losses, whereas the reduction of ordinary income by capital losses is
severely restricted.
The Section 1211(b) Limitations. (Pg 757)

Relevant Code: Section 1221

Section 1221(a): For purposes of this substitle, the term “capital asset” means property held by the
taxpayer (whether or not connected with his trade or business), but does not include—

(1) Stock in trade of the taxpayer or other property of a kind which would properly be included in
the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the
taxpayer primarily for sale to customers in the ordinary course of his trade or business;

(2) Property, used in his trade or business, of a character which is subject to the allowance for
depreciation provided in Section 167, or real property used in his trade or business;

CASES
Mauldin v. Commissioner

United States Court of Appeals for the Tenth Circuit 195 F.2d 714 (1952)

Rule of Law: Gain from the sale of property is entitled to capital gains treatment if the
property is held for investment purposes.

Facts: In 1920, C.E. Mauldin (plaintiff) entered an agreement to purchase 160 acres of land in New
Mexico. At the time, Mauldin intended to use the land for cattle feeding. However, by the time he
acquired the property in 1921, he had changed his mind, in part because the cattle business was no
longer a wise or profitable venture. In 1924, Mauldin attempted to sell the land but was unable to
do so. In order to facilitate its sale, Mauldin subdivided the land into small lots. In 1939 and 1940,
Mauldin actively sold a substantial number of lots by listing the property with real estate agents
and advertising the lots throughout town. At this point, Mauldin decided to hold onto what
remained of the original tract of land for investment purposes. He then entered the lumber business
in 1940, after which he no longer actively advertised the lots. However, between 1940 and 1945,
Mauldin’s land became the subject of popular demand. Thus, Mauldin regularly sold lots between
1940 and 1945, selling a substantial portion of them in 1945. By 1945, Mauldin only had 20 acres
remaining in his possession. A large portion of his income during this time was attributable to the
sale of lots. In his tax return for 1944 and 1945, Mauldin characterized the lots he sold as long-
term capital assets. The Commissioner (defendant) disallowed this characterization and treated
gain from the sales as ordinary income. The Tax Court sustained the Commissioner’s ruling. Note
– He did not get a loss and did not actively sell lots—and as such he was not technically in the real
estate business.

Issue: Is gain from the sale of property entitled to capital gains treatment if the property is
held for investment purposes?
Holding and Reasoning (Murrah, J.): Yes. Whether the disposition of property is entitled to capital
gains treatment is determined on a case-by-case basis. The primary consideration is the purpose
for which the property is held. If held in the ordinary course of business, any gains upon disposition
are taxable at ordinary income tax rates. If held for investment purposes, any gains upon
disposition are entitled to capital gains treatment. Another relevant factor is the purpose for which
the property is acquired, but this is not dispositive. Thus, in Richards v. Commissioner (1936), a
taxpayer who originally acquired land to use as a farm but later subdivided it and sold the parcels
was deemed to be in the business of selling real estate. The continuity and frequency of property
sales are other relevant factors. Taxpayers who continuously sell land and partition it in order to
facilitate sales are more likely engaged in the business of selling real estate than taxpayers who
only occasionally sell land. Here, Mauldin did not acquire the property to sell it in the ordinary
course of business. He purchased the land for cattle feeding, intending to go into the cattle feeding
business. But after abandoning the intent to enter the cattle feeding business, and upon subdividing
the land into parcels in order to facilitate sales, Mauldin clearly entered the business of selling real
estate. While Mauldin argues that he left the business of selling real estate in order to start a lumber
company in 1940, the record shows that he continuously sold lots from 1940 to 1945, and that he
made a substantial portion of his sales in 1945. A considerable part of his income from 1940 to
1945 came from the sale of the lots. Based on these facts, this court cannot say that the Tax Court
was clearly erroneous in ruling that Mauldin was in the business of selling real estate in 1944 and
1945. The judgment of the Tax Court is therefore affirmed.

 Key point pointed out in class: “There is no fixed formula or rule of thumb for determining
whether property sold by the taxpayer was held by him primarily for sale tocustomers in
the ordinary course of his trade or business. Each case, must, in the last analysis, rest upon
its own facts. There are a number of helpful factors, however, to point the way, among
which are the purposes for which the property was acquired, whether for sale or investment;
and continuity and frequency of sales as opposed to isolated transaction. Pg. 764
o Keep Hansche 475 F.2d 429  Review this, as this is mentioned in class.


Malat v. Riddell

United States Supreme Court 383 U.S. 569 (1966)

Rule of Law: A taxpayer holds property primarily for sale in the ordinary course of business
if such sale is of first and principal importance to the taxpayer.

Facts: Malat (plaintiff), as part of a joint venture, acquired a parcel of land. The joint venturers
encountered difficulties in obtaining zoning. As a result, they decided to end the venture and sell
the parcel. Malat characterized the proceeds from the sale as a capital gain. According to Malat,
the profits were entitled to capital gains treatment because the joint venturers purchased the land
with the intent to develop it for rental. Riddell (defendant) disagreed with Malat’s characterization.
Riddell argued that the joint venturers had a dual purpose in acquiring the land. They intended to
either develop the land for rental or for sale, depending on which option proved more profitable.
Riddell determined that Malat held the property primarily for sale in the ordinary course of
business and that therefore, the proceeds from the sale must be treated as ordinary income. The
District Court sustained Riddell’s determination, agreeing that the joint venturers had a dual
purpose in purchasing the property and that Malat failed to demonstrate that the property was not
held primarily for sale in the ordinary course of business. The Court of Appeals affirmed. The
United States Supreme Court granted certiorari.

Issue: Does a taxpayer hold property primarily for sale in the ordinary course of business if
such sale is of first and principal importance to the taxpayer?

Holding and Reasoning (Per curiam): Yes. Section 1221(1) of the Internal Revenue Code states
that proceeds from the sale of land are not entitled to capital gains treatment if the land has been
held primarily for sale in the ordinary course of business. Here, Riddell argues that “primarily”
means “substantial.” However, the term must be read according to its ordinary, everyday usage.
Reading the term literally, this Court holds that “primarily” means “of first importance” or
“principally.” Because the courts below applied a different and incorrect interpretation of the term
“primarily,” this Court remands the case to the District Court for proceedings in accordance with
this opinion. The judgment is vacated and remanded.

Bielfeldt v. Commissioner United States Court of Appeals for the Seventh Circuit 231 F.3d 1035
(2000)

Rule of Law: Under federal tax law, assets held as inventory for sale to customers are not
capital assets.

Facts: Gary Bielfeldt (plaintiff) speculatively purchased and sold U.S. Treasury securities. When
Bielfeldt identified an opportunity to make a short-term profit on Treasury securities, he entered
into buy-and-sell transactions with primary dealers. Bielfeldt participated in Treasury auctions
only a few weeks each year at most. Bielfeldt would also go for months without owning any
Treasury securities at all. After sustaining heavy losses on the securities transactions, Bielfeldt
sought a refund of $85 million on his federal income taxes, which exceeded the annual capital-loss
deduction limit. The United States Tax Court entered judgment in favor of the United States
government (defendant). Bielfeldt appealed to the United States Court of Appeals for the Seventh
Circuit.

Issue: Under federal tax law, are assets held as inventory for sale to customers capital assets?

Holding and Reasoning (Posner, J.): No. Stock in trade and inventory held primarily for sale to
customers are excluded from the definition of capital assets under 26 U.S.C. § 1221 and from the
capital-loss deduction limit of $3,000 per year under 26 U.S.C. § 1211(b). A taxpayer’s ordinary
business activities may involve holding what otherwise might be considered capital assets, such as
real estate and securities, as inventory primarily for sale to customers. If so, the taxpayer’s gains
or losses from the sale of those assets constitute ordinary income or losses, not capital gains or
losses. Section 1221(a)(1) permits a dealer holding inventory for sale to customers to treat his gains
from those sales as ordinary income. Here, Bielfeldt asserts that he is a dealer in Treasury
securities. Bielfeldt seeks to deduct the losses resulting from his securities transactions from
his ordinary income pursuant to § 1221(a)(1). Based on his argument that the losses are ordinary
losses, Bielfeldt claims an exemption from the capital-loss deduction limit. However, Bielfeldt
was a trader, not a dealer. Bielfeldt was in the business of speculating in the value of Treasury
securities. A dealer earns a commission or markup in exchange for selling inventory that he owns.
Unlike a dealer, Bielfeldt did not maintain an inventory of securities or derive income from
providing a service to customers. As a trader, Bielfeldt generated income from the fluctuation in
value of the assets that he bought and sold. Therefore, Bielfeldt’s sale of his securities resulted in
capital losses, not ordinary losses. The $3,000 annual limit on capital-loss deductions applies to
Bielfeldt. Accordingly, the judgment of the tax court is affirmed.

 Note, this guy… was investing a lot. And selling and purchasing a lot—as a trader in the
form as in this is your active job as oppose to an “investor” or dealer solely.
o “The standard distinction between a dealer and a trader is that the dealer’s income
is based on the service he provides in the chain of distribution of the goods he buys
and resells, rather than on fluctuations in the market value of those goods while the
trader’s income is based not on any service he provides but rather on, precisely,
fluctuations in the market value of the securities or other assets that he transacts in”
o “Unlike a floor specialist, Bielfeldt undertook no obligation to maintain an orderly
market in Treasury securities. He did not maintain an inventory of securities; and
because he skipped auctions that didn’t seem likely to produce the glut that was the
basis of his speculative profits, there were months on end in which he could not
have provided liquidity by selling from inventory because he had no Treasury
securities. In some of the tax years, in question he participated in as a few as 6
percent of the Auctions, and never did he participate in more than 15 percent. As a
result, he was out of the market for as much as 200 days a year. He was a speculator,
period. As the Federal Reserve Bank of New York, which kept track of Bielfeldt’s
trading in Treasury securities and sent updates to the IRS, put it, “his activities are
in most cases outright speculation on interest rate movements.””
 NOTE: The relationship between the asset to the individual is a key point.

Notes from Class:

- The nature and purpose of acquisition of the property and the duration of ownership
- The extent and nature of the taxpayer efforts to sell the property
- The number, extent, continuity, and substantially of the sales
- The extent of subdividing developing and advertising to increase sales
- The use of a business offer for the sale of the property
- The character and degree of the supervision or control exercised by the taxpayer over any
representative selling the propert
- The time and effort the taxpayer habitually devoted to the property
o NOTE: Generally, no one factor is determinative. A court will typical based on the
factors at hand.
DEPRECIATIONS

Under Section 167 and 168, the Code treat depreciation as if it were operating expense by allowing
an annual deduction for exhaustion and wear and tear (including predictable obsolescence) of
property. The business community utilized the concept in the determination of annual profits even
before there was a Federal income tax. Section 167 technically allows the deduction for
depreciation and has requirements and special rules relating to depreciation. At one time, Section
167 also contained the rules for calculating the deduction (“historical depreciations”) rules
generally were relatively subjective tests particular to the individual taxpayer.

- Today, depreciation is generally calculated under the rules in Section 168, which is referred
to as the Modified Accelerated Cost Recovery System (MACRS), and which uses more
objective rules computing depreciations.

Prerequisite for Deductions: Section 167(a) and 168(a) restrict the depreciation deduction to
either (1) property used in a trade or business or (2) property held for the production of income.

o Thus inventory and property held for sale to customers are placed outside the scope
of the section. And so is property that is held for merely personal use, even though
it too declines in value over a period of time.
o Generally, only property that will be consumed, wear out, become obsolete, or
otherwise becomes useless to the taxpayer can qualify for the deduction. Thus,
unimproved realty is said to be non-depreciable, meaning, in the tax sense, it cannot
be the subject of a depreciation deduction.
 Depreciation is a cost-spreading device.

Useful Life Concept. The useful life employed for depreciation also pegs the so-called depreciation
rate. For example, if an asset is to be depreciated for five years and the deductions are to be spread
equally over that period, the rate must be 20 percent (100/5yrs) in order for the entire cost to be
taken into account over the life of the asset.

- In 1971 Congress enacted the asset depreciation range ADR system which set various class
lives for property which were shorter lives thn under prior depreciation rules. MACRS
discussed in detail later, generally continues the trend of shortening the useful lives of asset.

Depreciable Amount: The word cost is used loosely in the above discussion. One may have a
machine that cost her nothing but which is subject to depreciation. If, for example, she acquired
the machine by gift, Section 1015 accords her a basis for the property. And she is entitled to write
off that basis by way of depreciation deductions. Thus, it is cost or other basis which is deductible
by way of depreciation. Because cost or other basis fixes the overall limits of the depreciation
deductions; for any asset, an acquisition of a depreciable asset has the same ultimate impact
on taxable income as any deductible expense; only the amount of the expenditure is
deductible.

- When the depreciable cost of an asset is “recovered” (charged off by way of

depreciation deductions) depreciation deductions stop.
 o MACRS rules no simply disregard salvage value in the computation of the
deduction.

Depreciation Methods. With respect to property used in one’s business or held for the production
if income, once the property’s depreciable amount and useful life are known, several different
methods of depreciation may be available to the taxpayer. These methods regulate the timing of
depreciation deductions within the cost limitations indicated above. One can spread the
depreciation deduction evenly over the life of the property, the so called “straight-line” method.
There are also several expressly authorized “accelerated” methods of depreciation which increase
depreciation deduction in the early years of the asset’s useful life and decrease them in later years.
However, the depreciable amount (i.e. the total amount of depreciation) that can ultimately be
claimed is generally the same under each of the methods.

Basis adjustment arising out of depreciation are governed by Section 1016(a)(2). The downward
adjustment required is at least the amount of depreciation deduction permitted (allowable) under
the depreciation method employed by the taxpayer. This is because depreciation method employed
by the taxpayer. This is because depreciation in the he nature of a continuing expense, unaffected
by the success or failure of the taxpayer’s business, and Congress does not permit a taxpayer to
time depreciation deductions for one’s own convenience any more than one can time deductions
for rent or salary.

- Thus, while depreciation does not involve a current pay-out, as salaryexpense may, it is
properly viewed as a continuing expense each year just as if it were salary expenses paid
or accrued. Consequently, basis is reduced even if the taxpayer claims no depreciation
deduction. The amount of depreciation allowable is determined in accordance with the
depreciation method that has been adopted by the taxpayer.
o If one has claimed no depreication and has therefore adopted no method, the statute
specifies that allowable depreciation is to be determined under the straight-line
method.
o What’s the effect of taking excessive deduction for depreciation?

Note: Basis for Gifts Section 1015(a): If the property was acquired by gift after December 31,
1920, the basis shal be the same as it would be in the hands of the donor or the last preceding
owner by whom it was not acquired by gift, except that if such basis (adjusted for the period before
the date of the gift as provided in section 1016) is greater than the fair market value of the property
at the time of the gift, then for the purpose of determining loss the basis shall be such fair market
value.

- So basically… if the donor basis is greater than the fair market value, then you pay fair
market value.
o Note: The term “allowable” deduction are the deductions that are permitted under
the depreciated method employed by the taxpayer.
Congress has said that it should, the sensible notion being that if the taxpayer’s taxable income has
been reduced by the deduction, even improperly, the taxpayer has had the use of the capital
expenditure to that extent. Thus, in general, the plan has been to call for doward basis adjustment
for depreciation “allowed” but not less than the amount allowable.

- Note: While alloweable depreciation always works as a reduction in basis, depreciation

allowed in excess of the amount allowable effects a basis reduction only to the extent that
the excess resulted in a reduction of the taxpayer’s taxes.

MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)

- The basic underlying concepts of the system which are discussed above (useful life,
depreciable amount, depreciations methods, and basis adjustments) are applicable to
all types of tangible depreciable property—real and personal, and new and used.
- Yet different detailed rules apply to the different types of property. The current
depreciation system applicable to tangible property, in effect since 1987, is the Modified
Accelerated Cost Recovery System (MACRS), found in Section 168.
o MACRS is mandatory, not elective, although some elections may be made within
the system. MACRS applies to most tangible depreciable property. Intangible
property does not qualify for MACRS treatment; however, under Section 197
certain acquired intangibles may be “amortized” over 15 years. The statute also
excludes from MARCS property depreciated under a method NOT expressed in
terms of time of utility, such as property depreciated under the unit-of-production
method. If for any reason MACRS does not apply, Section 167 may apply and a
separate set of rules comes into play.
 Thus, MACRS is not exclusive depreciation deduction section; it is
mandatory when it applies, but if it is inapplicable, generally Section
167 or section 197 is used.

Recovery period. Under MACRS taxpayers recover the entire cost of tangible depreciable property
over lives known as “recovery periods” that are, for the most part, shorter than the useful lives
previously employed. This is accomplished by assigning all such property to one of several classes
with predetermined useful lives or recovery periods.

- As such: A happy consequence is elimination of controversy between government and

taxpayer over the useful life of the property.
1. Under MACRS each item of property is assigned to one of several classifications which is
generally dependent upon the property’s class life under the ADR system.
2. Under each classification items of property are assigned to an applicable recovery period
which becomes the period of time over which that property is depreciated.
a. Most personal property is classified as either “3-year”, “5-year”, or “7-year”
property which has respective recovery periods of 3, 5, or 7 years.
i. Some property specifically listed in Section 168(e)(3) is subject to special
classification. For example, automobiles are specifically placed within the
5-year class with a 5-year recovery period. Almost all depreciable real
property is assigned either a 27.5 year or a 39-year recovery period.
Disregard of Salvage Value. As previously discussed, MACRS completed disregards salvage value
in the computation of depreciation, both simplying the computation and alleviating controversy
over the amount of salvage value.

Depreciation Methods. MACRS provides that the depreciation methods available with respect to
property also depend upon the classification of property. Depending on the classification of
property, MACRS employs the 200% declining balance method, the 150% declining balance
method, and the straight-line method.

- If of the accelerated depreciation methods is employed, there is a switch within the system
to the straight-line method in the year when the straight-line method yields a greater
depreciation allowance.

Notes from Class on Depreciations: Section Outlines

- Function of Depreciation
- Eligible Assets
- Key Variables
- MARCS: Section 168
- Alternative Depreciation

Depreciation is a major deduction. According to a class charts, the top ten business tax expenditure
is accelerated depreciation is the biggest deductions. Accelerated depreciation is the reason why
the upper income bracket not pay as much taxes.

 The tax laws generally allow companies to write off their capital investments faster than
the assets actually wear out. Accelerated depreciation is technically a tax deferral but so
long as a company continues to invest, the tax deferral tends to be indefinite.
 Under State Income Tax system—most States tend to piggy back federal income tax law
rules—and when that happens, sometimes it gets cut into the state revenue. This then
requires the states to decouple themselves with the federal revenue code—or otherwise do
something different to make up the revenue loss.

Example given in the casebook: Stitching Machine

- How should the cost of those asset be offset against the revenue the asset produces?
o Expensing, Section 179: Election to Expense Certain Depreciable Business Aspect
(Note—this was aimed for small business. Because of phase out no big companies
get anything)
 You can carry forward the deduction for two decades, namely, twenty years.
o Note: 179(b) notes dollar limitation which cannot exceed $500,000

Function of Depreciation: To spread the cost allocation mechanism.

Section 167(a)

1. How the asset is used is a key question? This determines the calculation of depreciation
2. Is it a physical asset that is able to wear out or become obsolete?
a. Note: Land by itself cannot be depreciation
b. Note: An asset does not need to go down in value for it to qualify for depreciation.
i. Depreciation is not a rainy-day fund. It is simply a book-keeping entry—
not representing any amount that is set aside in any kind of account.

Mechanism:

(Basis / Life) (x) Method

Basis of the asset which includes the debt or all other cost related to the purchase of the asset.

What is the useful life? Life is usually a “guestimate” – the question is how long will it last in this
taxpayers business. The life is guessed.

Straight Line Method: 80k/8=10k in depreciation allowed. It is the same amount every year—
thus it is called the straight-line method and it is the same amount every year. The basis here is
fixed and life is determined via guessing how long the material would last.

200% DB Acceleration Depreciation: It allows you the 200% depreciation…getting more generous
deduction up front and then smaller deduction in the future.

- Why? Senate Committee on Finance Report No 1622: “Liberalized depreciation policies

should assist modernization and expansion of industrial capacity, with resulting economic
growth, increased production, and a higher standard of living”
o But in reality… this has no real impact. U.S. is less of a manufacturing industry
now and greater tech industry.

“The useful life employed for depreciation also pegs the so-called depreciation Rate. For example,
if an asset is to be depreciated for five years and the deduction (100eprcent/5yrs) in order for the
entire cost to be taken into account over the life of the asset.” Pg. 430

Section 168:

Step One: Is it real estate? No. Then go to step two. If Yes. Figure out if its residential or
nonresidential.

Step Two: Is this property special property? (Defined in 168(e)(3) – this shows you the
classification of the asset)

- Note: Most of the time, it will not be special property.

Step Three: You go onto the classification that defines the class-life designated for the asset/item.
 - The relationship between depreciation to basis and to gain and loss on disposition.

Bonus Depreciation: The foregoing analysis of depreciation of personal property does not provide
complete picture. In addition to the above rules, including Section 168(k)

Time-value of money… Youre not paying it back with any interest.

Note: 1221 If something is not a capital asset then it is ordinary gain/ordinary income. Note to
1221(2) property that used in his trade or business of a character which is subject to the allowance
for depreciation provided in section 167, or real property used in his trade or business.

Keep this section in mind: On Section 1231: Upon disposition, the gain or losses will be treated as
capital gains but only if the sum of the years transaction are positive. Or, in other word, if at the
end of the year the 1231 gain exceed the loss, then they are long-term capital gain. But if they do
not, the loss will be ordinary income.

Have your gain and loss in separate boxes because that eventually leads to less loss from a tax
perspective.

Recharacterization of Gain

- Read the code – understanding the historical context helps with

Pg. 822-23

1. Is it more than one year ago?

2. Is it connected with his business?
a. It was destroyed in the business
3. Painting purchased for 4k but he realized a gain of 8k.
a. Now we have a 4k gain from the painting.
4. From the prior problem, we have a 2k loss from the car
a. That results in a total of 2k gain (4k-2k)
5. Thus… that gain will go into the main hotchpot… which is then a total of 10+2=12k gain.
a. In another prior problem, there was a 10k gain earlier gain from the sale of building.
6. Now we have a total of 12k gain…
a. That 12k gain will be potentially cpital gain because we don’t know anything else
about the past five years. If there are no loss in the prior five years, then this
constitute as 12k capital gain.

1. Problem E  In this case, the land was purchased for 50k and it was sold again 30k. He
bought it at a high price thinking it was valuable and it turned out it was not.
 a. 30k-50k = -20k LOSS
i. Now, we have a 20k loss.
ii. This offset the capital gain of 12k
iii. 12k-20k = -8k LOSS
1. Now this will be all an ordinary loss.
2. If there was no loss… it will constitute an ordinary loss.
a. And thus all the transaction will be ordinary gain and loss
because the ultimate realization is a loss.
2. Problem F  If the land was investment instead of used for business.. If it is an investment
it would be a capital asset.
a. Thus now it is not a 1231 asset at all unless it was involuntary converted.
b. Now… the 12k is capital gain.
c. But… the 20k loss
d. Now… you will have to do a 3k month because you have a short-term loss of 20k.
i. 12-20= -8k
ii. Then every year 8-3k = 5k then you can deduct another 3k next year which
is 5k-3k = then you can deduct the last 2k the final third year.
3. Problem G?
4. Problem H ?
a. Tax payer had a net loss of 6k.
5. Problem I ?
a. 10k (1231) gain… how will the 12k be characterized?
i. Now it is not a string of losses…
1. So now we have to figure out how much is relevant. True capital do
not apply here.
2.

Problem 3:

- Merchant who has been in business more than four years sells her sole proprietorship
consistening of the following assets, all of which, except for the inventory have been held
for more than one year.
o Inventory is not a capital asset.
o Good will is not excluded from being a capital asset—and as such that is a capital
asset that is held in relation to trade for business BUT it is being sold that is not
involuntary converted so it does not fall under 1231.
 Thus… not an involuntary conversion.
o Land is 1231 but not capital asset.
o Machinery is depreciable asset so not capital but is 1231
o Building is depreciable asset so not capital but it is 1231
- Inventory is ordinary income
- Covenants not to compete are ordinary income.
Cost of an item 80k

- Depreciation to date: 70k

o Adjusted basis: 10k
- Sold for: 34k
o Gain: 24k
o Sec 1231: If this was sold for a loss, it would be ordinary income loss (say if sold
for 4k, there is ordinary income loss of 6k).
 But since it is a gain, 24k-10k=14k GAIN
 It will be a capital gain…that will be taxed at 15% or 20%--depending on
your income bracket.
 Upon disposition, on a gain, it is a capital gain.

Section 1250

Pg 841

Problem 2: Since it is in the year 2000, there won’t be ordinary income. Property has been held for
17years

Land Building

Amount Realized 110k 890k

Adjusted Basis (100k) ? = 440k Cost: 780k

Gain 20k 890-440 = 450k

20,000 (x) 17yrs = 340k Depreciations!

780k- 340k = 440k (Note because this is real estate it depreciates on a straight-line method)

The depreciation is taxed at maximum of 25% long term capital gain.. Thus 340k (x) 25%

450k-340k = 110k  This will now go into the Section 1231 maze –and will be determined
whether it gets ordinary income loss or capital gain treatment.
HOW MUCH INCOME IS OFFSET BY DEDUCTION?
Deduction are a matter of legislative grace.

- There is no constitutional obstacle to a tax on gross income. This is not to say the 16 th
Amendment would support an unapportioned tax on gross receipts, for the term “incomes”
as used there connotes gain at least to the extent that a mere return of capital is not
“income.” But expenses incurred earning income might constitutionally be disregarded in
the computation of the tax. For this reason, deductions are spoken as a matter of “legislative
grace;” and it is at least true that as a taxpayer has no constitutional right to deduction, a
taxpayer must find a statuary provision that specifically allows the deduction claimed.
- The individual income tax rates are applied to “taxable income.” In general, under Section
63 taxable income is gross income minus the deductions provided in the statute.
o Business deductions are allowed.
o Documentation of the line of demarcation of which is business deduction and what
is non-business, which is NOT deductible.

ORDINARY AND NECESSARY

162(a): There shall be allowed as a deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business, including—

(1) A reasonable allowance for salaries or other compensation for personal services actually
rendered;
(2) Traveling expenses (including amounts expended fr meals and lodging other than amounts
which are lavish or extravagant under the circumstances) while away from home in the
pursuit of a trade or business; and
(3) Rentals or other payments required to be made as a condition to the continued use or
possession, for the purposes of the trade or business, of property to which the taxpayer has
not taken or is not taking title or in which he has no equity.

Key points:

- Ordinary
- Necessary
- Incurred during the taxable year
- In carrying on a trade or business

This is not some obscure code section—this is the key provision for business deduction. The
question, as such, is whether the cost would be ductibible under “ordinary” and “necessary”
provision?

- “Ordinary in this context does not mean that the paymenst must be habitual or normal in
the sense that the same taxpayer will have to make them often. None theless, the expenses
is ordinary one because we know from experience that payments for such a purpose,
 whether the amount is large or small, are common and accepted means of defense against
attack” Pg. 338

Welch v. Helvering (290 U.S. 111 (1933))

Rule of Law: Expenditures for ordinary and necessary business expenses may be deducted
from gross income if incurred while carrying on a trade or business.

Facts: E.L. Welch Company was a corporation involved in the grain business. Welch (plaintiff)
served as the secretary of the corporation before it went bankrupt and was discharged from its
debts. Welch was subsequently hired as a commission agent for Kellogg Company, a corporation
also in the grain business. In an effort to reconnect with old customers he had known through the
E.L. Welch Company, and to strengthen his credit and reputation, Welch substantially repaid E.L.
Welch’s debts. On his tax return for those years, Welch deducted the amount of these repayments
as business expenses. The Commissioner determined that the repayments were not necessary and
ordinary expenses, but rather capital outlay for the purpose of developing his reputation and good
will. The Board of Tax Appeals held for the Commissioner. The Court of Appeals affirmed.

Issue: May expenditures for ordinary and necessary business expenses be deducted from
gross income if incurred while carrying on a trade or business?

Holding and Reasoning (Cardozo, J.): Yes. Section 162 of the Tax Code states that expenses for
ordinary and necessary business expenses may be deducted from gross income if incurred while
carrying on a trade or business. Many payments may be deemed a necessary expense, but not all
necessary payments are ordinary. An expense does not need to be a regular and recurring event in
order to be ordinary. Even one-time payments can be ordinary. For instance, if a company defends
itself in a lawsuit by hiring an attorney, the attorney’s fees is probably an ordinary expense within
the meaning of § 162. But ultimately, whether an expense is both necessary and ordinary is a
determination based on the specific facts at hand. Here, the Commissioner found that the
repayment of debt was more akin to capital outlay than a necessary and ordinary business expense.
Taxpayers do from time to time pay off debts they are not legally obligated to repay, deeming it
necessary for the success of their business. However, such payments are far from ordinary, even
where such repayments prove beneficial. Welch’s repayment of his former corporation’s debt is
not an ordinary business expense. Rather, it is more akin to a capital outlay meant to build up his
reputation and good will. Therefore, the judgment of the Court of Appeals is affirmed.

Class Notes:

- Relating to the case (Welch), if this was a smart expenditure, a good call, it does not mean
that it will be deductible.
o This was a good business idea even though it is non-deductible.

Problem Pg. 340

1. Taxpayer is a businessman, local politician who is also an officer-director of a saving and

loan association of which he was a founder. When partially due to his mismanagement, the
 savings and loans began to go under, he voluntarily donated nearly one half a million
dollars to help bail it out. Is the payment deductible under Section 162?
i. This was allowed as a deduction. How was this reconcile? Footnote no. 1
on Pg. 339-40 allowed this.
1. Write this opinion out from the footnote.

Midland Empire Packing Co. v. Commissioner (United States Tax Court, 14 T.C. 635
(1950))

Rule of Law: An expenditure is currently deductible as a repair to property if it is made

solely to keep the property in an ordinarily efficient operating condition.

Facts: Midland Empire Packing Co. (Midland) (plaintiff) was in business for about 25 years.
Midland used its basement to cure and store meats and hides. Occasionally, water seeped into the
basement rooms, but the water drained out and did not interfere with Midland’s operations.
Eventually, however, oil from a nearby refinery began seeping into Midland’s basement and water
wells. Unlike the water seepage, the oil did not drain out. It emitted a strong odor and the fumes
created a fire hazard. The Federal meat inspectors advised Midland that it must either stop using
the wells and oil-proof the basement, or shut down the plant. Accordingly, Midland oil-proofed
the basement by adding concrete lining to the walls and the floor. Midland then deducted this
expenditure as a necessary and ordinary business expense.

Issue: Is an expenditure currently deductible as a repair to property if it is made solely to

keep the property in an ordinarily efficient operating condition?

Holding and Reasoning (Arundell, J.): Yes. Expenditures to repair property are deductible as an
ordinary and necessary business expense. On the other hand, expenditures for capital outlay are
capitalized and deducted in installments over the capital asset’s useful life. In order to determine
whether expenditures are repairs or capital outlay, courts must look to the purpose of the
expenditure. If the expenditure is a replacement of the property in whole or in part, or if it is an
improvement intended to add to the property’s value, prolong its life, or change its use, then it is a
capital outlay. In American Bemberg Corporation, 10 T.C. 361 (1948), the Tax Court held that
expenditures undertaken to prevent cave-ins of soil at a manufacturing plant were deductible
repairs because they were not intended to improve or prolong the life of the property. Rather, the
expenditures were made solely to allow the plant to continue its operations on the same scale and
level of efficiency and over the same period of time as before the cave-ins became a threat.
Similarly, Midland’s expenditure was a repair to its basement and not a capital outlay. Midland
only made the expenditure in order to continue its operations. The oil-proofing did not add value
to or improve the basement in any way, nor did it adapt the property to a new use. Furthermore,
the oil-proofing did not prolong the life of the property beyond what it was before the oil began
seeping in. Although the oil-proofing did prevent further seepage of water, the basement was not
improved because the water never interfered with Midland’s operations. The repairs only served
to allow Midland to use its basement for the same purpose over its probable useful life. Therefore,
the expenditure is deductible as a repair. The Commissioner argues that although the expenditure
was necessary, it was not ordinary. However, the Supreme Court held in Welch v. Helvering, 290
U.S. 111 (1933), that ordinary does not necessarily mean regular or frequent, and that even a one-
time payment can be ordinary if it is a common and accepted manner of dealing with a particular
threat to a business. Here, it is reasonable to deem oil-proofing as the ordinary course of action
when the property would otherwise be unusable. For these reasons, Midland’s expenditure for the
concrete lining is deductible as an ordinary and necessary business expense.

Class Notes:

- Another key takeaway is that even if it is not deductible, it can be depreciable.

o Pg. 341: “The question is only one of timing… but of course timing is important.”
 Pg. 162 – regulation… Pg 344, foot note no.1
 If it is a repair you deduct it immediately
 If it is a reconditioning/good will  Viewed as depreciable.
 If it is an improvement It will just be added into the adjusted basis the
improvement into the cost of the total basis.
o Adding value If it adds value then it is depreciable.
o But… if it is necessity to maintain the ordinary and necessary in carrying out any
trade of business would lend it to allow the recondition of the wall to be a repair
that is ordinary and necessary.
- The test is very difficult here… to determine what is ordinary and necessary.

Morton Frank v. Commissioner (United States Tax Court - 20 T.C. 511 (1953))
Rule of Law: Expenses incurred while investigating and looking for a new business are not
deductible as ordinary and necessary business expenses.

Facts: Morton Frank and Agnes Dodds Frank (plaintiffs) were husband and wife. The Franks were
interested in purchasing and operating a newspaper or radio station. At the end of November 1945,
they left for a trip throughout the United States in an effort to find potential newspapers or radio
stations to purchase. In November 1946, they purchased a newspaper in Ohio. Until they made the
purchase, the Franks incurred significant travel, communication, and legal expenses. The Franks
deducted $5,965 of these expenditures as ordinary and necessary business expenses.

Issue: Are expenses incurred while investigating and looking for a new business deductible
as ordinary and necessary business expenses?

Holding and Reasoning (Van Fossan, J.): No. Section 23(a)(1) of the Internal Revenue Code allows
deductions for expenses made in carrying on a trade or business. Although the same provision also
states that expenses made in pursuit of a trade or business are deductible, “pursuit” refers to
expenses related to or made in the course of a trade or business. This suggests that there must be
an existing trade or business. Because the Franks did not have an existing business, their expenses
were not related to the conduct of business, as the statute requires. Rather, their travel,
communication, and legal expenses were preparatory to beginning a business venture. Therefore,
the Franks are not entitled to the claimed business expense deduction.
Class Notes:

 Were you carrying on the trade or business WHEN you paid the money?
o In this case, the folks didn’t. As such, they incurred these expenses when they did
not even have the business.
 Pg. 362: Provides the outline on pursuit, and the fact that the search must
be made while the business already exist.

Section 195: Start-up Expenditure

Ultimate bottom line you cannot deduct the expenditure made on start-ups. However, there is an
opportunity for depreciation tax benefit. This is a mid-way solution/response, which is one can
amortized the cost over a 180months (15years). Amortized is similar to depreciable but it is always
straight-line deduction, and not the 200% bonus deduction rule.

195(c)(1):

Pg 168

1. Determine the deductibility under Section 162 and 195 of expenses of incurred in the
following situations.
a. What does this have to do with doctor? Nothing. There is your answer to Section
162. This is because this had nothing to do with being a doctor—she has expenses
in preliminary investigation…maybe this includes Section 195 but not Section 162.
i. Note. Section 195 can apply but not Section 162
b. The facts are the same as in (a), above, except that Tycoon rather than having been
a doctor, was a successful developer of residential and shopping center properties.
i. This is close enough for government work. As such, at the time she incurred
all these expenses, she was already involved in real estate development.
This would be close enough, and therefore probably deductible as 162—if
we define the business as real estate development.
c. T
i. Diversification is a good idea—but sports team versus the developer of
resdeintial and sales properties… this would be different enough to not be
deductible under Section 162
1. But if in the event that you were using expenses in order to search
to acquire some osrt of start-up… then this could be amortized over
years for 180months under Section 195.
2. Write this problem out.
a. Agency is unsuccessful in finding Spouse a job.
i. Were the expenses incurred as that person already involved in the trade or
business?
1. Answer is no. Pg. 366
 b. Agency is successful in finding Spouse a job.
c. Agency fee was contingent
i. The agency works, then I’m trying to find a job, but it is contingent, and
you don’t pay them unless you get a job. Then spouse gets a job, then she
pays. Thus the payments were contingent—only becomes due once the
spouse gets to work.
1. But spouse did not pay the expenses until spouse was working—and
by that point the spouse was carrying on a business and trade (even
though the money was paid only after working—and the agency was
looking prior to finding the job in the first place).
d. D
i. As long as the business is seeking a job as sectrary, then it is the same trade
or business—and as such, this would fall under the exception of Section
195. It is relatively continuous, and therefore the person will get the
deduction
e. Agency is successful in finding a job—but not secretary but a teller.
i. Since it is a different trade or business, there is no deduction under Section
195.

Class Notes: 10/31/2017  What is REASONABLE?

Exacto Spring Corp. v. Commissioner

Rule of Law: Under federal tax law, a corporate salary is presumptively reasonable and
deductible as a business expense if the dividends are far higher than expected.

Facts: Exacto Spring Corp. (Exacto) (plaintiff) was a closely held corporation in the business of
manufacturing precision springs. Exacto paid one of its cofounders a salary of $1.3 million in 1993
and $1 million in 1994. This cofounder, in addition to being the principal owner of Exacto, also
operated as the chief executive officer, chief manufacturing executive, chief research and
development officer, and chief sales and marketing executive. Exacto’s investors received larger
dividends than anticipated during 1993 and 1994, expecting a 13 percent return but actually
receiving a return of more than 20 percent. Exacto deducted the cofounder’s salaries as business
expenses on its 1993 and 1994 federal tax returns. The commissioner of internal revenue
(commissioner) (defendant) determined that the salaries were too high and that a large portion was
actually a dividend taxable to Exacto. Exacto filed a petition challenging the commissioner’s
determination in the United States Tax Court. The tax court applied a seven-factor test and held
that a large portion of the salaries was reasonable, but that the remaining portion was still a
dividend. Exacto appealed.

Issue: Under federal tax law, is a corporate salary presumptively reasonable and deductible
as a business expense if the dividends are far higher than expected?
Holding and Reasoning (Posner, C.J.): Yes. A corporation may deduct reasonable salaries as a
business expense. Under the independent-investor analysis, a salary is presumptively reasonable
if the dividends returned to investors are far higher than expected. This is only a presumption
because scenarios exist in which a corporate executive is not being compensated for his work, but
rather is being given a dividend disguised as a salary. In this case, the tax court applied a seven-
factor test to determine whether the salary paid by Exacto should have been considered a dividend.
However, this seven-factor test is an inadequate measure, as many of the factors contain duplicate
analysis or do not directly prevent dividends from being disguised as salary. Furthermore, this test
leaves too much discretion for judges. No judge is adequately equipped to determine whether the
salary of a corporate executive is reasonable. The more recent trend and proper test is the
independent-investor analysis. Here, Exacto’s investors expected a 13 percent return during 1993
and 1994, but actually received a more than 20 percent return. These dividends were far higher
than expected. Thus, the salaries paid to the cofounder were presumptively reasonable under the
independent-investor analysis. The evidence does not suggest that the cofounder was not being
reasonably compensated for his work, as he was running the company and operating in four
executive roles. Because the cofounder’s salaries were reasonable, Exacto may deduct the entire
amount as a business expense. Accordingly, the tax court’s ruling is reversed.

Harolds Club v. Commissioner

Rule of Law: The entire amount paid under a contingent compensation agreement is
deductible, even if greater than what would ordinarily be paid, if it is paid pursuant to a free
bargain.

Facts: Raymond I. Smith (plaintiff) owned and operated an illegal gaming establishment in
California that later moved to Nevada. The gaming establishment was established in Nevada as
Harolds Club (Club). Smith’s two sons wholly owned the Club. In 1935, Smith agreed to manage
the Club for a salary and bonus. In 1941, Smith and his sons decided to enter a fixed percentage
arrangement. Smith suggested that he should receive 20 percent of the profits, since Smith was the
“brains” of the organization. The sons agreed. From 1952–1956, Smith’s salary ranged from
$350,000 to $560,000. The Club deducted this amount as a reasonable salary. The
Commissioner (defendant) determined that the Club could not deduct the full value of Smith’s
salary. At the Tax Court, competing gaming establishments testified that Smith’s salary was
reasonable. The Tax Court ruled in favor of the Commissioner.

Issue: Is the entire amount paid under a contingent compensation agreement deductible,
even if greater than what would ordinarily be paid, if it is paid pursuant to a free bargain?

Holding and Reasoning (Hamley, J.): Yes. Section 162(a)(1) of the Internal Revenue Code allows
business expense deductions for reasonable salaries. Corresponding Treasury Regulations
generally state that, where salaries are contingent on a company’s net profits, the entire amount is
deductible even if greater than what would normally be paid. The only conditions are that the
employer and employee reach the contingent compensation agreement through a free bargain and
that the agreement is reasonable at the time it is formed. Whether there is a free bargain is a fact-
based determination, and any evidence demonstrating the employer’s ability to exercise
independent judgment is pertinent. Here, the Club paid Smith according to a contingent
compensation plan and claimed business expense deductions for Smith’s entire salary. Smith’s
salary was greater than what would ordinarily be deductible under § 162(a)(1). Nevertheless, the
entire salary is deductible if made pursuant to a free bargain. The Tax Court found that Smith and
his sons did not reach the contingent compensation agreement through a free bargain. It found that
the family relationship between Smith and his sons was one in which Smith exercised domination
and control over his sons. This court agrees. Although the sons were two competent adults, their
family relationship with Smith suggests that the agreement could not be the result of a free bargain.
The Club argues that the sons agreed to the salary plan in recognition of Smith’s true worth to the
organization. But this argument is contrary to evidence indicating that the sons agreed to the salary
because Smith was the “brains” behind the organization, not because his services were
indispensible. The Club notes that the Commissioner previously found Smith’s salaries from
1941–1949 to be reasonable. The Club argues that if the salary was reasonable when the sons were
younger and more easily dominated by their father, the salary should still be reasonable from 1952–
1956, when the sons were older. But the Commissioner did not consider the issue before this court
today, which is whether the compensation agreement was the result of a free bargain. Therefore,
the Commissioner’s previous rulings are inapplicable here. This court finds that the agreement
was not made pursuant to a free bargain and that the salary is not reasonable under § 162(a)(1).
Therefore, a deduction for Smith’s entire salary is disallowed. The Club argues that if it cannot
deduct Smith’s salary as a business expense, the salary would be double-taxed. Smith would pay
an income tax on the sum while the Club would pay a corporate tax. Regardless of whether
Smith’s salary might be double-taxed, § 162(a)(1) clearly states that only reasonable salaries
are deductible. The Club’s interpretation of the statute entirely omits the “reasonable”
requirement, arguing that deductions should only be disallowed if the Club is disguising forms of
income as salary. But § 162(a)(1) applies a reasonableness requirement regardless of whether
income is disguised as salary. The Club further argues that this court’s interpretation of the Internal
Revenue Code transforms the Code into a regulatory provision that controls salaries. It is true that
the Code regulates businesses in that it dissuades them from disguising dividends or other income
as salaries to employees. But this regulatory effect is only incident to the Tax Code, and not its
primary purpose. For the foregoing reasons, the judgment of the Tax Court is affirmed.

Class Notes:

- In this case, the number is quite irrelevant. What sort of facts do you think you want to take
a look at when evaluating a similar pattern?
o Other salaries in the industry/comparable salaries?
o How the company actually makes it money?
o The organization/structure of the organization?
o Amount of workWhat are exactly his duties/
o Overseers and Board of Directors
o Skill-set of the individual
o Industry ExpertsWhether the salary is typical OR is the person worth the salary?
 o Shareholders getting profitable expectations Dividends
 Dividend pay to the shareholders is important because it suggests that
perhaps the alleged salary could be dividends in disguised.
o

Rosenspan v. United States (US Court of Appeals for the Second Circuit 438 F.2d 905
(1971))

Rule of Law: In order to deduct traveling expenses incurred in connection with a business,
the taxpayer must maintain a place of residence.

Facts: Robert Rosenspan (plaintiff) was a traveling jewelry salesman. In 1962 and 1964, he was
employed by New York City jewelers. He traveled throughout the Midwest 300 days a year and
did not maintain a permanent residence. Rosenspan sought to deduct his expenses for meals and
lodging while traveling. The Commissioner (defendant) disallowed the deduction. Rosenspan sued
for a refund in the District Court for the Eastern District of New York. The District Court dismissed
the complaint.

Issue: Can a taxpayer who does not maintain a place of residence deduct travel expenses
incurred in connection with a business?

Holding and Reasoning (Friendly, J.): No. Section 162(a)(2) of the Internal Revenue Code allows
deductions for ordinary and necessary traveling expenses incurred while away from home in the
pursuit of a trade or business. An earlier version of § 162 only allowed deductions for the amount
in excess of what a taxpayer would normally spend at home. This version required a complicated
calculation of a taxpayer’s ordinary expenditures. Also, under this version, a taxpayer without a
home was not eligible to deduct traveling expenses from his income. In 1921, Congress amended
the statute to its current version, allowing the deduction of the full amount of meals and lodging
expenses. Thus, the current version of § 162(a)(2) no longer requires the calculation of a taxpayer’s
ordinary expenses. In amending the statute in this regard, Congress gave no indication that it meant
to also amend the statute to allow a traveler without a home to take a deduction. It merely meant
to simplify the application of § 162(a)(2) by no longer requiring a complicated calculation.
Ultimately, the question of whether a traveler without a home may claim a deduction is resolved
by the plain language of the statute. A taxpayer cannot be “away from home” unless the taxpayer
has a home. Therefore, a taxpayer without a home is not eligible to take a deduction under §
162(a)(2). Rosenspan argues that for the purposes of § 162(a)(2), a taxpayer’s home is his business
headquarters. Supreme Court cases have not resolved whether a taxpayer’s home is in fact his
business headquarters or his place of residence. In Commissioner v. Flowers (1946), Flowers
maintained his residence in Mississippi but worked for a company in Alabama. Flowers claimed
deductions for his transportation, meals, and lodging. The Court held that Flowers could only be
eligible for the deduction on three conditions. First, the traveling expense must be reasonable and
necessary. Second, the expense must be made while away from home. Third, there must be a direct
connection between the expenditure and the business pursued, and the expenditure must be
necessary or beneficial to the pursuit of the business. Flowers’ employer gained nothing from
Flowers’ decision to live in Mississippi and travel extensively to Alabama. Thus, the Court held
that Flowers’ travels failed to meet the third requirement, which required the travel to
bestow some benefit to the business, and Flowers was ineligible to take the deduction. In
Peurifoy v. Commissioner, 358 U.S. 59 (1958), the Court upheld the ruling in Flowers that travel
expenses should only be deducted when necessary for business operations. In Commissioner v.
Stidger, 386 U.S. 287 (1967), the Court held that a Marine could not deduct expenses while
stationed in Japan, in part because Congress does not allow travel and transportation allowances
for military personnel. In each of these cases, the Court declined to rule on whether the place
of business or the place of residence is a taxpayer’s home for the purpose of § 162(a)(1). The
Commissioner in each of these cases argued that a taxpayer’s place of business was his home
under § 162(a)(1). But the Commissioner did not prevail on that basis. Instead, the Commissioner
prevailed on the basis that the taxpayers’ travels were not sufficiently beneficial to their respective
businesses. The Commissioner does not need his interpretation of § 162(a)(1) in order to prevail
in a great deal of similar cases. Thus, the Commissioner should not be adversely affected by
this court’s reliance on the ordinary meaning of the term “home” in holding that § 162(a)(1)
refers to a place of residence. The resolution of Rosenspan’s case rests on the fact that
Rosenspan had no home to be away from during his travels. Because Rosenspan does not
satisfy the second condition under Flowers, the judgment dismissing Rosenspan’s complaint
is affirmed.

CLASS NOTES:
Menard, 560 F.3d 620 1998  Case mentioned in class…

- Key take away is… that you have to look at the complete compensation package.
o The contract would provide severance pay and other packages.
o The pure number game of compensation is by itself not enough. There are other
provision in the compensation payment agreement.

Keep in mind section 162(m)  This allows compensation package to be created under
performance goal.

- Note: IRS also allows them to change metrics of the goalpost that would enable greater
bonuses.
- “The limitation reflects congressional recognition of the rational distinction between the
taxpayer with a permanent residence—whose travel costs represent duplication of expense
or at least an incidence of expense which the existence of this permanent residence
demonstrates he would not incur absent business compulsion—and the taxpayer without
such a residence.” Pg. 391

Section 162(a): Paragraph 2 “For the purpose of paragraph (2), the taxpayer shall not be treated
as being temporarily away from home during any period of employment if such period exceeds
one year.

- Regulation Section 1.262-1(b)(5)

o Google IRS 463 https://www.irs.gov/forms-pubs/publication-463
Starr’s Estate v. Commissioner
Rule of Law: For tax purposes, if the practical effect of a rental agreement is to pass title, the
rental agreement can be treated as a sale.

Facts: Delano T. Starr (plaintiff) leased a fire sprinkler system and had it installed at his plant.
Under the terms of the lease, Starr was to pay a rental fee of $1,240 annually for five years, for a
total of $6,200. A sprinkler system usually sells for about $4,960. After the five-year term, Starr
had the option of renewing the lease for five more years for a rental fee of $32 per year. If Starr
chose not to renew the lease, the lessor had the right to remove the sprinkler system from Starr’s
plant. Sprinkler systems are usually custom-made and have very little value after they are removed.
It is not uncommon for lessees of sprinkler systems to keep them permanently. Starr claimed
deductions for rental payments amounting to $6,200. The Commissioner (defendant) disallowed
the deductions. The Tax Court upheld the disallowance, holding that the rental payments were in
actuality capital expenditures.

Issue: For tax purposes, if the practical effect of a rental agreement is to pass title, can the
rental agreement be treated as a sale?

Holding and Reasoning (Chambers, J.): Yes. Expenditures for necessary rental fees are fully
deductible in the year they are incurred. Capital expenditures, however, are not. Instead, the
expenditure is deducted over the useful life of the acquired asset. The Commissioner need not treat
a taxpayer’s expenditures as rental fees merely because the taxpayer characterizes them as such.
If the practical effect of a rental agreement is to pass title, the Commissioner may treat the rental
as a sale for tax purposes. Here, Starr entered into a rental agreement to lease the sprinkler system
for a number of years. However, the evidence demonstrates that the transaction was actually a sale.
By paying $6,200 for the first five years, Starr essentially paid the normal purchase price of a
sprinkler system plus interest. It is apparent that the $32 rental fee for the five additional years was
nothing more than a service charge. It is also apparent that Starr would probably have kept the
sprinkler system permanently, since it would have had very little value upon removal from his
plant. This is a considerably different situation from that in Western Contracting Corporation v.
Commissioner, 271 F. 2d 694 (1959), which Starr’s estate relies upon. In Western, the taxpayer
did not pay the full sale price of the equipment plus interest. Nor was it likely he could keep the
equipment at the end of the lease without paying a substantial additional fee because the equipment
still had considerable value at the end of the lease. Western therefore does not support Starr’s
estate. However, Starr may be entitled to deduct the interest he paid on the sprinkler system. The
judgment of the Tax Court is reversed and remanded for further proceedings.

Traveling Expenses: Key points

- Going from home to the job is never deductible as traveling expenses.

- Going to a temporary work location, if you have a regular job placement, then that is
deductible for traveling expenses.
- If you have a second job, the same thing follows for the first job. Also not deductible.
 o But going from your first job to your second job, that is always deductible.

Pg 402 Problems

Problem 4:

- Temporary works for employer in city where temporary and his family live.
o (a): In this case, because it is temporary, notice family temporary is still in the city,
then the temporary assignment in another city is deductible. Everything would be
deductible for living expenses.
 Note it is for less than a year so it is deductible.
o (b)  Note in this problem, after 8months, it is extended to 15month. In other
words, it is more than one year. The Revenue Rule provides that the first 8 months
that we thought it was temporary it would be deductible. After the 8month, now
that we know it is not temporary, that is not deductible anymore.
o (c)  The new home, even though it is temporary, there is no expenses away from
home. As such, that becomes the new home, so there is no living expenses that
would be deductible.

Problem 1:

- Commuter owns ahome in Suburb of city and drives to work in City each day. He eats
lunch in various restaurants in City.
o (a) May Commuter deduct his cots of transportation made/or meals?
 Unless there is a business connection—these are just personal expenses.
 How about the city? Well you don’t have to live in the city. That’s personal.
You have the choice to live nearer to work.
 Pg. 1102-03  (e)

Problem 2(c)

- Husband works in city and lives in city. Nothing to deduct

- Wife works in metro and has an apartment in metro  her home is the closest to the one
she works. That becomes her tax payer home. Thus the expenses to metro not deductible.
o Her expenses to go from metro to city are also not deductible because she is not
going to for the purpose of work. Thus, that traveling expenses is not deductible.

Section 162(a)  Place of a business for a member of Congress

Section 162(h)  Exception for State legislature.

(h) State legislators’ travel expenses away from home

(1) In generalFor purposes of subsection (a), in the case of any individual who is a State legislator
at any time during the taxable year and who makes an election under this subsection for the taxable
year—
(A) the place of residence of such individual within the legislative district which he represented
shall be considered his home,

(B) he shall be deemed to have expended for living expenses (in connection with his trade or
business as a legislator) an amount equal to the sum of the amounts determined by multiplying
each legislative day of such individual during the taxable year by the greater of—

(i) the amount generally allowable with respect to such day to employees of the State of which he
is a legislator for per diem while away from home, to the extent such amount does not exceed 110
percent of the amount described in clause (ii) with respect to such day, or

(ii) the amount generally allowable with respect to such day to employees of the executive branch
of the Federal Government for per diem while away from home but serving in the United States,
and

(C) he shall be deemed to be away from home in the pursuit of a trade or business on each
legislative day.

- However, a state judge however, cannot get any deduction. As found… in Robertson 190
F.3d 392.

Problem 5 (Pg. 403)

- Traveler flies from her personal and tax home in NY to a business meeting in FL on
Monday. The meeting ends late Wednesday and she flies home on Friday afternoon after
two days in the sunshine.
o (a)  To what extent are they deductible.
 Meals and Lodging are usually analyzed together… however, transportation
is a separate category.
 Analytically consider transportation separately.
 Thus Transportation is all or nothing. Pg. 1102-3 read 1.162-2
Traveling Expenses (b)
 Thus, Monday, Tuesday, Wednesday  3/5 days is a more than 50% 
thus transportation is fully deductible.
 Thus, MTW  Meals and Lodging are deductible
o But for TF Meals and Lodging are not deductible.
 Thus, keep in mind, meal and lodging are analyzed separately from
traveling.
o (b)May travelor deduct her spouses deduction if he/she joins them?
 Section 274(m)(3) answers the question!
 J
o (c) What if Traveler stays until Sunday?
 Now transportation is not deductible because TFSATSUN are FOUR
DAYS
  It will be now completely non-deductible!
 But meals and lodging for MTW will be deductible.
o (d) What results in (a) if taxpayer takes a cruise ship leaving Wednesday and
arriving Friday? See 274(m)(1)
 “to the extent such expenses exceed twice the aggregate per diem amounts
for days of such transportation.”
 twice the per diem
 for the purpose of per diem, means the highest amount given to the
gov’t employees.
 For 2016 per dieum is $428 (2) => $856
 For this problem: 856(3) = $2568
o Cannot exceed that amount
o (e)  What would happen in (a) if the travel is to Mexico City?
 Meaning a foreign destination. There is another code citation.
 Section 274(c)(2) EXCEPTION
o 3/5 would be deductible but not the 2/5 days.
 Thus, transportation will all be deductible because it
does not exceed one week.
 BUT if it was for more than week…
 Then 274(c)(2)(B)
o If the non-business portion is less
than 25%, then you are allowed to
deduct transportation.
o (f) What results in (e) if the traveler went to Mexico City, Thursday, Friday, and
Monday and Tuesday, and return Friday.
 In this case, Saturday and Sunday are standby days because of work on
Monday.
 Because Thursday to next Friday is more than a week…
o Therefore, the 2/3 of the transportation will be deductible,
and the other 1/3 will not be.
o (g) Section 274(h)
 Evaluate (A) and (B) and (C) and (D)
 Note: If a country wants to become part of North America, for
subsection 274—if a country is willing to negotiate a bilateral or
multilateral between US and another country—then it will count as
North America for the purpose of 274(h)(3)(A)
 Note, since in this problem, the place is in Mexico City and falls in North
America, then you can have transportation deductible even for conference
- Note: What if it was a cruise ship?
o Section 274(h)(3)(B)
EDUCATIONAL EXPENSES

Parameter of Section 162: “

Problem 1: Pg 416

1. Dentist went into orthodontics. Is that similar enough?

a. The answer to this problem would be, according to IRS, that is close enough to
existing trade or business—that was not sufficiently different. AS such, this would
be deductible because it was a current existing or trade experience.
b. Lets do DENISE, she is the lawyer.
i. LLM tax course. The caselaw here is mixed. LLM in taxation can be
possibly deducted. But it is much more favorable to return to school for
LLM than JD.

Note: Attending law school is non-deductible. The expenditure qualifies for a new trade or
business. This is in the regulation on Pg 1109 (it is highlighted)

The relationship to the education to the taxpayer current business. Or, in other words, Pg. 415
If it were usual in lawyer for lawyers in practice, then it would be ordinary and usual.

ENTERTAINMENT EXPENSES

Sec. 274

Pg 244: “Taxpayer must substantiate each and every element of each expenditure must be
adequately substantiated.” Footnote 32

Pg. 424:

1. Employee spends $200 taking three business clients to a local restaurant discussing
particular business matter. The $200 cost included $10 in tax and $30 in tip. They each
have two martinis before lunch.
a. To what extent are Employee expenses deductible?
i. Was it business matter? Yes
ii. Is it lavish or extravagant? That is a question of fact.
1. If you get over these two hurdles… You can only deduct 50%
a. Thus, you can deduct only $100.00 for that.
b. To what extent are the meals deductible if the lunch is merely to touch base with
the clients?
i. Non-deductible. Touch base with a client is a good idea sure… but it ain’t
deductible. It is not directly related to associated to business expenses.
c. What results if Employee merely sends the three clients to lunch without going
herself but picks up their $150 tab?
i. Section 274(k) – not deductible because you have to be there for it to be
deductible on that behalf.
 d. Uber fare to transportation to the client?
i. That’s fully deductible as it is travel expenses.
e. What results in (a) if Employer reimburse employee for the $200 tab.
i. In this case the 50% hair cut won’t apply. As such, fully deductible for the
employer
2. Business persons who is in NY takes folks to Hamilton.
a. Congress cares about this. 274(l)(1) In general… for any tickets or activity as
described in 274(d)  This cannot exceed any face value of any ticket.
i. Basically… lets do this together.
1. 3X100 = $300  Ticket price.
2. Sec 274(n)50% meal and entertainment expenses.
a. $300/2 = $150 deductible ONLY

BAD DEBTS

Pg. 425, Section 165 Learn to distinction between business/trade and personal losses.

If it is a business or corporation  Done  You get deduction.

But if it is a human… well.. now it is squishy again

165(a)IF not recoverable, in the case of an individual go to Section 165(c)

267(a)(1)  Take note of this one as well.

Howard S. Bugbee v. Commissioner

Rule of Law: Under § 166, a debtor-creditor relationship is established if two parties intend
to create an enforceable obligation of repayment.

Facts: Howard S. Bugbee (plaintiff) operated a beer parlor in California. In 1957, Bugbee met Paul
Billings, a customer at the beer parlor. The two became friends and often discussed possible
business ventures for Billings to pursue. Bugbee believed that Billings could successfully pursue
some of these ventures and began loaning money to Billings. Between September 1958 and
December 1960, Bugbee loaned Billings a total of $19,750 represented by 11 different notes. The
notes were unconditional and unsecured. They indicated an interest rate of about six percent.
However, Billings never paid interest or repaid any part of the principal. During the period when
Bugbee loaned Billings money, Billings had little money and was unemployed. Although Bugbee
expected Billings to pay him back after one of his business ventures became successful, repayment
was not predicated on Billings’ success. At trial, Billings acknowledged that the loan was personal
and he had an obligation to repay it regardless of his success. In 1967, Bugbee requested several
times that Billings repay the money, but Billings did not. On his tax return for 1966, Bugbee
reported a bad debt to Billings and claimed the $19,750 as a short-term capital loss. The
Commissioner (defendant) disallowed the bad debt deduction on the grounds that Bugbee had not
established that a debtor-creditor relationship existed between Bugbee and Billings.
Issue: Under § 166, is a debtor-creditor relationship established if two parties intend to create
an enforceable obligation of repayment?

Holding and Reasoning (Sterrett, J.): Yes. Section 166 of the Internal Revenue Code allows
deductions for bad debts arising from a debtor-creditor relationship. The debt must be a bona fide,
enforceable obligation for a fixed and determinable sum. The parties to the transaction must share
the intent to create an enforceable obligation to repay. The Commissioner states that there are
several factors demonstrating the debt was not bona fide. The Commissioner first argues that
because Bugbee expected to share in the profits from Billings’ prospective business, the advance
in money was not a loan. Although Bugbee expected that Billings would repay the money after
establishing a successful venture, it is clear that the loan was personal in nature and that Bugbee
expected Billings to repay the money from whatever source available. At trial, Billings admitted
he was personally liable for the money and that he intended to repay it if possible. Furthermore,
there is no evidence of an agreement between Bugbee and Billings that Bugbee would be entitled
to a share of any business venture profits. This court therefore rejects this argument. The
Commissioner also argues that the loans were not bona fide because Bugbee could not have
expected his unemployed friend to repay an unsecured loan. The Commissioner cites the fact that
Billings had no other source of support, that Billings failed to make any interest payments, and
that the possibility of success in a business venture was entirely speculative. It is true that Billings
had little money when he received the loan. However, the issue of whether a bona fide loan was
made revolves around the intent of the parties, not on the wisdom of making a loan. Here, the
evidence demonstrates that Bugbee genuinely believed Billings could successfully establish a
business venture and that he would be repaid eventually. This is sufficient to demonstrate Bugbee
had the requisite intent under § 166. The Commissioner next points out that because Billings had
little money, Bugbee could only have expected repayment upon success of a business venture. The
Commissioner argues that repayment was contingent upon Billings’ success in a business venture
and therefore, the obligation to repay was non-enforceable. In Zimmerman v. United States, 318
F. 2d 611 (1963), a court held a debt was not bona fide where the obligation to repay was contingent
upon the success of an organization. Here, however, both Bugbee and Billings testified that they
both understood repayment was obligatory regardless of Billings’ success in his business ventures.
Billings himself testified he was personally obligated to repay the loan and that he intended to if
possible. Billings’ obligation to repay was not contingent upon the success of his ventures. Finally,
the Commissioner argues that the close friendship between Bugbee and Billings required the
classification of the loan as a gift. However, the existence of a personal relationship does not
preclude the possibility that the advance of money was a loan and not a gift. In fact, Bugbee’s
financial records indicate that he is not wealthy enough to advance such sums without expecting
to be repaid. In light of the above, Bugbee has established that a debtor-creditor relationship existed
between Bugbee and Billings. Therefore, the Commissioner’s ruling is reversed.

Class Notes:

This ain’t no debt yo!

Pg 848 These dudes were friends! Thus it is a gift…

… if it is a gift, no deduction.
 1. First threshold question—is it a debt at all? Is the debt bad?
a. This seems like a gift in Bugbee…
2. Note This activity took place in his business activity.
a. But unlike someone who is running a tab/floating a business credit. This loan has
nothing to do with the business—it is making an investment unrelated to the
business and Bugbee was not in the small of making small loans. He was not a
lender he was not in the trade of lending/banking.
i. Thus it is subject to capital loss but NOT deductible in business expenses.

Charles J. Haslam v. Commissioner

Rule of Law: A taxpayer is entitled to deduct a loss from the guarantee of a bad debt to a
wholly owned corporation from ordinary income if the taxpayer’s dominant motivation is to
protect his employee interest in the corporation.

Facts: In 1954, Charles J. Haslam (plaintiff) and Earl Canavan formed Northern Explosives, Inc.
(Northern), a corporation specializing in the sale and distribution of explosives. Haslam had
previously gained experience with explosives through the army, school, and prior jobs. In 1957,
Haslam became the sole owner of Northern, having invested a total of $20,000. In 1960, Northern
had financial troubles and required a loan to continue its operations. Haslam therefore guaranteed
a loan to Northern by the National Commercial Bank and Trust Company of Albany, New York
(National) in the amount of $100,000. The loan was secured by some of Haslam’s securities and
his personal residence. Northern went bankrupt in 1964. Because Northern was unable to repay
the loan to National, National sold some of Haslam’s securities, resulting in the repayment of
$55,956 of Northern’s debt. Until Northern went bankrupt, Haslam was employed full-time by
Northern and earned approximately $15,000 annually. Haslam’s income came primarily from his
employment with Northern. After Northern went bankrupt, Haslam obtained employment in an
unrelated field for a smaller salary, as skills in explosives were not marketable at the time. On his
tax return for 1967, Haslam claimed a business bad debt in the amount of $55,956. The
Commissioner (defendant) ruled that Haslam could only claim the amount as a nonbusiness bad
debt.

Issue: Is a taxpayer entitled to deduct a loss from the guarantee of a bad debt to a wholly
owned corporation from ordinary income if the taxpayer’s dominant motivation is to protect
his employee interest in the corporation?

Holding and Reasoning (Forrester, J.): Yes. Section 166 of the Internal Revenue Code allows a
taxpayer to deduct losses from the guarantee of bad debts. Business bad debts are deducted from
ordinary income, whereas nonbusiness bad debts are deducted as short-term capital losses.
Whether a bad debt is business or nonbusiness depends on the relationship between the guarantee
of the debt and the taxpayer’s trade or business. Guarantees made merely to protect a taxpayer’s
interest in a corporation as an investor are not deductible as business bad debts. The guarantee
must be proximately related to the taxpayer’s trade or business as an employee. Where a taxpayer
has an interest as both an employee and a stockholder, the taxpayer must demonstrate that the
dominant motive behind the guarantee was to protect the taxpayer’s interest as an employee. In
United States v. Generes, 405 U.S. 93 (1972), a taxpayer was both an employee and shareholder
of a corporation. He had invested $40,000 in his corporation. He worked six to eight hours weekly
for an annual salary of $12,000. He worked full-time at another corporation, where he earned a
salary of $19,000. A few of his family members also had employment and investment interests in
the corporation. The Supreme Court held that the facts did not demonstrate the taxpayer’s
dominant motive in guaranteeing a loan to the corporation was to protect his employee interest.
Here, the guarantee undertaken by Haslam is clearly related to his trade or business as an employee.
However, because Haslam is both an employee and investor of the corporation, Haslam must
demonstrate that his dominant motive was to protect his employee interest. Haslam’s case is unlike
that in Generes. Haslam was employed full-time by Northern. He was not employed anywhere else
and his salary from Northern was his main source of income. His skills were not marketable outside
of Northern, as evidenced by the fact that he took a job in an unrelated field for a smaller salary
after Northern went bankrupt. These facts demonstrate that Haslam’s dominant motive behind
guaranteeing the loan was to preserve his employment rather than to protect his investment.
Haslam stood to lose $20,000 as an investor, but stood to lose $15,000 annually as an employee.
His employment with Northern was worth much more than his investment and was therefore his
dominant motive for guaranteeing the loan. Accordingly, the loss is deductible as a business bad
debt.

Class Notes:

- The idea was that people made the loan as possibly as an investment. It was made for
investment purposes and business purposes—that would ultimately produce and save a job.
Thus, there were mixed motives.

This case highlights to the fact that there will be several kinds of motives instead of just one kind
of motive.

Attempt to determine the predominant motive—i.e. get in the mind of the investor/lender—get
into the psychology and try to determine a single motive as oppose to one.

Pg. 857 Problem 1: First, what method of accounting did the lawyer uses? If he is on the cash-
method, then there would be no deduction or bad debt deduction because he never included it in
his income and thus was not taxed. But if he was on the accrual method, and since all of the event
have taken place, and since the amount is readily determinable, and it has been taxed previously.
As such, under the accrual method, there would be a deduction under Section 166.

ILLEGALITY OR IMPROPRIETY
Section 162(c) is the applicable statute on improper use of bribes and kickbacks.

Section 280E – Expenditures in Connections with the Illegal Sale of Drugs.

Pg 596
Commissioner v. Tellier
Rule of Law: Courts may not disallow deductions otherwise allowable under section 162 of
the Internal Revenue Code on public policy grounds for legal expenses incurred in defense
of criminal charges.

Facts: In 1956, Walter F. Tellier (plaintiff) was indicted on 36 counts of fraud and conspiracy
related to his business underwriting stock offerings and purchasing securities for resale. He was
convicted on all counts. Tellier spent $22,964.20 in legal expenses incurred for his defense. He
deducted this amount as an ordinary and necessary business expense. The Commissioner
(defendant) disallowed the deduction. The Tax Court sustained the Commissioner’s disallowance.
The Court of Appeals reversed. The United States Supreme Court granted certiorari.

Issue: May courts disallow deductions otherwise allowable under section 162 of the Internal
Revenue Code on public policy grounds for legal expenses incurred in defense of criminal
charges?

Holding and Reasoning (Stewart, J.): No. Section 162 of the Internal Revenue Code requires that
an expenditure be incurred in carrying on a business. The origin and character of the claim that
leads to the expense determines whether an expense is personal or business in nature. Section 162
also requires that an expenditure be both necessary and ordinary. An expenditure is necessary if it
is appropriate and helpful. An expenditure is ordinary if it is currently deductible and not incurred
to procure a capital asset. Here, Tellier meets all the requirements of section 162. His legal
expenses were incurred in defense of charges stemming from his business activities. Thus, the
expense was business in nature, not personal. Furthermore, there is no dispute that the expenditure
was both necessary and ordinary, particularly because he did not incur the expense in procuring a
capital asset. Therefore, Tellier is entitled to a deduction for his legal fees under section 162. The
Commissioner does not dispute this. Instead, the Commissioner argues that the deduction must be
disallowed on public policy grounds. This Court disagrees. Congress has made clear that our
system of federal income tax is not intended to punish wrongdoing. It is only intended to tax the
net income of every individual. The same principle extends to tax deductions. Congress does not
require that a taxpayer demonstrate his trade or business is legitimate or lawful before he is entitled
to deductions. For this reason, in Commissioner v. Sullivan, 356 U.S. 27 (1958), this Court allowed
a deduction of rent and wages even where the expenses were illegal. Similarly, in Lilly v.
Commissioner, 343 U.S. 90 (1952), this Court allowed deductions for unethical payments made
by opticians. Finally, in Commissioner v. Heininger, 320 U.S. 467 (1943), this Court allowed
deductions for lawyer’s fees incurred to defend against an accusation of fraud. These cases make
clear that the illegality of Tellier’s business activities does not prevent him from taking a deduction
for business expenses otherwise allowable by section 162. To be sure, Congress has the power to
disallow deductions for expenses incurred in certain types of activities. But where Congress has
not explicitly done so through legislation, this Court will not disallow otherwise valid deductions
unless the allowance will sharply frustrate national or state polices that proscribe such conduct.
For instance, in Hoover Express Co. v. United States (1958), this Court disallowed a deduction
that otherwise would have been allowable. There, the taxpayers had been fined for violating a state
statute. Allowing a deduction for the payment of a fine would serve to decrease the penalty, thereby
frustrating the state’s intention of punishing the taxpayer to a certain degree. Here, in contrast,
there is no suggestion that national or state policy requires the disallowance of the deduction.
Tellier’s use of a lawyer to defend himself does not offend public policy. Rather, it is his
constitutional right to incur legal expenses for his defense. Congress has already imposed
punishment on Tellier for his illegal activities. There is no reason for this Court to punish Tellier
beyond what Congress has set out by disallowing the deduction at issue. For the foregoing reasons,
the judgment of the Court of Appeals is affirmed.

Higgins v. Commissioner
Rule of Law: Under § 23(a) of the Internal Revenue Code, personal investment activities do
not constitute carrying on a trade or business.

Facts: Higgins (plaintiff) had substantial holdings in both real estate and securities. He set up
offices in New York and Paris and hired employees dedicated to overseeing his investments. His
staff handled the day-to-day responsibilities related to the investments under Higgins’ close
supervision. Their responsibilities included keeping records and collecting interest and dividends.
Higgins relied on these offices in this manner for over thirty years. In 1932 and 1933, Higgins
deducted the salaries of his employees and other expenditures related to his two offices as ordinary
and necessary business expenses. The Commissioner (defendant) disallowed the deductions on the
grounds that personal investment activities did not constitute the carrying on of a business.
However, the Commissioner conceded to the Board of Tax Appeals that Higgins’ real estate
activities constituted a business. The Board of Tax Appeals held that insofar as the expenditures
related to Higgins’ real estate, the expenditures were deductible. The activities related to his
securities, on the other hand, did not constitute the carrying on of a business and were non-
deductible. Accordingly, the Board of Tax Appeals ordered the apportionment of Higgins’
expenses between his real estate and securities operations. The Court of Appeals affirmed. The
Supreme Court granted certiorari.

Issue: Under § 23(a) of the Internal Revenue Code, do personal investment activities
constitute carrying on a trade or business?

Holding and Reasoning (Reed, J.): No. There is no statutory guidance or regulation that interprets
the phrase “carrying on a business.” Thus, the issue of whether an activity constitutes the carrying
on of a trade or business is a factual determination. Here, Higgins’ offices existed solely to handle
his personal investment activities. In that regard, the offices’ activities do not constitute the
carrying on of a trade or business. Higgins relies on cases that have disallowed deductions for
personal investments where the taxpayer’s activities were sporadic. He argues that because he
continuously carried on his investment activities for over thirty years, his case is distinct from that
of a small investor who only occasionally conducts such activities. But however extensively he
may have carried on these activities, they do not constitute carrying on a trade or business.
Therefore, the judgment of the Court of Appeals is affirmed.
“No matter how large the estate or how continuous or extended the work required may be,
such facts are not sufficient as a matter of law to permit the courts to reverse the decision of
the Board.”

- The congressional reaction to Higgins decision was negative. But, instead of attempting to
mitigate the problem by defining a trade or business as including income-producing
activity, congress enacted what is now Section 212(1) and (2) as part of the Revenue Act
of 1942.
o “

Surasky v. United States

Rule of Law: Ordinary and necessary non-business expenses incurred for the production of
income are deductible from gross income.

Facts: Surasky (plaintiff) purchased 4,000 shares of Montgomery Ward & Co. at the advice of
Louis E. Wolfson, a substantial shareholder in the company. Wolfson developed an elaborate plan
that he believed would improve the company and result in an increase in its stock value. The plan
included such objectives as electing a new board of directors, introducing new management, and
ultimately achieving an increase in dividends. Wolfson, together with Surasky and other
stockholders, established a committee to implement the plan. In 1955, Surasky contributed
$17,000 to the committee in the hopes of generating more income from his investment. The
committee managed to achieve some of its stated goals. Three of the nine board members were
replaced and two original members of management resigned. Furthermore, the company enjoyed
an increase in dividends in the latter half of the year. Surasky deducted the $17,000 expenditure as
an ordinary and necessary non-business expense. The district court ruled that Surasky was not
entitled to the deduction.

Issue: Are ordinary and necessary non-business expenses incurred for the production of
income deductible from gross income?

Holding and Reasoning (Tuttle, C.J.): Yes. Section 212 of the Internal Revenue Code allows
deductions for ordinary and necessary non-business expenses incurred for the production of
income. The district court held that Surasky’s expenditure was not deductible because it was far
too speculative to form a direct and proximate connection to the production of income. In doing
so, the district court too stringently required the showing of a proximate relationship between the
expenditure and the desired production of income. While a reasonable connection between the
expenditure and the income produced is necessary, a taxpayer need not satisfy the common law
definition of proximate cause. It is sufficient that the taxpayer exercise reasonable business
judgment in making the expenditure. Here, Surasky clearly made the $17,000 payment in order to
increase the production of income from his investment. Although there was a chance of failure,
there was also a reasonable likelihood of success, and the positive results enjoyed by the committee
and Surasky only confirm that Surasky exercised reasonable business judgment in making the
expenditure. The district court erred in holding that the connection between Surasky’s expenditure
and the resulting production of income was insufficient. The judgment of the district court is
therefore reversed and the case is remanded to the district court for entry of judgment in Surasky’s
favor.

Note court Cases: Mayer 32 Fed. Cl. 149

Stranaham 43 TCM 883

INCOME-PRODUCING EXPENSES

Lowry v. United States

Rule of Law: A taxpayer need not make a bona fide offer to rent in order to convert a
personal residence into income producing property.

Facts: Edward G. Lowry, Jr. (plaintiff) was the de facto owner of a summer home located in
Martha’s Vineyard. The home was part of a community run by the Seven Gates Farm Corporation,
which held legal title to the property. In 1967, Lowry decided he no longer needed the summer
home. He immediately put the property up for sale. Lowry, who had extensive experience in real
estate transactions, recognized that home prices in Martha’s Vineyard were on the verge of a rapid
increase. Although the home had a fair market value of $50,000 in 1967, Lowry listed the property
for $150,000. Until the property was sold, Lowry returned each spring to open the home and
maintain the property. He came back each fall to close the home for the winter. He only slept in
the home when he stayed to maintain the property. He also used the home once a year to host the
Seven Gates Farm Corporation’s annual shareholders meeting. Lowry never used the property as
a personal residence after he listed it on the market. He did not attempt to rent the house because
he believed that a clean home would sell faster, and that furnishing the home for rental would be
financially unviable. Furthermore, the Seven Gates Farm Corporation had placed considerable
restrictions on renting the home. The property sold in 1973 for $150,000. In 1970, Lowry deducted
the expenses for the care and maintenance of the home on the grounds that he no longer used the
summer home as his personal residence. The Commissioner disallowed the deduction and assessed
a corresponding tax against Lowry. Lowry paid the tax under protest and brought suit in United
States District Court to recover the payment.

Issue: Must a taxpayer make a bona fide offer to rent in order to convert a personal residence
into income producing property?
Holding and Reasoning (Bownes, J.): No. Taxpayers may not deduct ordinary and necessary
expenses incurred for the maintenance of personal property. They may, however, deduct such
expenses when incurred for the maintenance of income producing property. A taxpayer who seeks
to deduct maintenance expenses for property previously held as a personal residence must
demonstrate conversion of the property into income producing property. The Tax Court once held
that a taxpayer must make a bona fide offer to rent in order to convert a personal residence into
income producing property. In Hulet P. Smith v. Commissioner, 26 T.C.M. 149 (1967), the Tax
Court rejected the rental test and only required an offer for sale together with an abandonment of
the property. In Frank A. Newcombe v. Commissioner, 54 T.C. 1298 (1970), however, the Tax
Court abandoned both tests. Instead, the court stated that the primary question was whether the
taxpayer intended an expectation of profit. The court set forth a list of factors relevant to this
question, such as the length of time the taxpayer lived in the property before abandonment, whether
the taxpayer used the home personally while it was unoccupied, the recreational nature of the
property, any attempts to rent the property, and whether the taxpayer made the offer to sell in an
attempt to realize post conversion appreciation. If a taxpayer’s true intent is to take advantage of
post-conversion appreciation and thereby maximize capital gain, the taxpayer has sufficiently
converted a personal residence into income producing property. Evidence that the taxpayer
immediately listed the property for sale tends to negate a taxpayer’s intent to realize post-
conversion appreciation. This court adopts the Newcombe test. Here, the facts indicate that Lowry
intended an expectation of profit because his true intent was to realize post-conversion
appreciation. Lowry, who was well-familiar with the housing market in the 1960s and 1970s, was
aware that property values in Martha’s Vineyard were about to rise dramatically. For this reason,
he listed the property for $150,000 when it was only worth $50,000 at the time. Lowry believed
that by keeping the property visible on the market and well-maintained, the home would eventually
sell at his listed price. His refusal to rent the property while he waited does not negate his intent to
realize income, since he had sound financial reasons for avoiding rental. Furthermore, the fact that
Lowry immediately placed the property on sale after abandoning the property does not negate his
principal intent. He immediately listed the property in order to keep it visible on the market and
thereby make it more profitable at the time of sale. As a result of his efforts, Lowry realized over
$100,000 in capital gain from the sale of the home. These facts demonstrate that Lowry possessed
a reasonable expectation of profit. This intent converted his personal residence into an income
producing property. Lowry is therefore entitled to deduct the expenses incurred for maintenance
of the property.

Meyer J. Fleischman v. Commissioner

United States Tax Court

45 T.C. 439 (1966)

Rule of Law

Legal expenses are deductible if they are incurred while defending against claims arising in
connection to a profit-seeking activity.
Facts

On February 22, 1955, Meyer J. Fleishman and Joan Ruth Francis entered an antenuptial
agreement. The agreement stipulated that in the event of a divorce, Meyer would pay Joan $5,000,
who in turn would release all her rights to Meyer’s property. In 1961, Joan initiated divorce
proceedings. In contravention of the prenuptial agreement, she sued for fair and equitable division
of all property. However, the court overseeing the divorce proceedings lacked authority to
invalidate the antenuptial agreement. Thus, in a separate action, Joan sued to set aside the
antenuptial agreement. The divorce was finalized in 1962 and Joan’s suit to set aside the
antenuptial agreement was dismissed. Meyer incurred $3,000 in legal fees defending the lawsuit
to invalidate the antenuptial agreement. He deducted the fees as an ordinary and necessary non-
business expense. The Commissioner (defendant) disallowed the deduction.

Issue

Are legal expenses deductible if they are incurred while defending against claims arising in
connection to a profit-seeking activity?

Holding and Reasoning (Simpson, J.)

Yes. Section 212 of the Internal Revenue Code allows deductions for ordinary and necessary non-
business expenses incurred in three enumerated contexts. Section 212(1) allows such deductions
when incurred for the production of income. Section 212(2), in pertinent part, allows such
deductions when incurred for the conservation of income. Section 212(3) allows for such expenses
when incurred for the acquisition of tax advice. Notwithstanding these provisions, personal legal
expenses are non-deductible. Here, Meyer relies on Carpenter v. United States (1964), in which
the court allowed deductions under § 212(3) for legal expenses incurred to obtain tax counsel
during a divorce proceeding. But § 212(3) is inapplicable to Meyer because he did not incur the
legal fees at issue to obtain tax advice. Section 212(1) is also inapplicable because there is no
evidence that Meyer incurred the legal expenses in order to produce income. Thus, Meyer can only
prevail if he can prove he incurred the legal expenses for the conservation of income under §
212(2). In United States v. Gilmore(1963), a taxpayer owned the controlling interest in three
corporations. His income derived primarily from these corporations. During his divorce
proceedings, his wife sought over half of his holdings in the corporations. He incurred significant
legal expenses defending against his wife’s claims, which he attempted to deduct under § 212(2)
as an expense incurred for the conservation of income. Looking to the origin and nature of the
claim giving rise to the taxpayer’s legal expenses, the Court ruled they were non-deductible
because they were personal in nature. Deductions are allowable under § 212(2) only if the claim
giving rise to legal expenses arises in connection with a profit-seeking activity. If the claim arises
in connection with a personal matter, such as a marital relationship, any expenses incurred in
defending against that claim are also personal and therefore non-deductible. In other words, if a
claim would not exist but for a marital relationship, the legal fees incurred in defending against
that claim are non-deductible. Here, Joan sought to set aside an antenuptial agreement on the
grounds that, as Meyer’s wife, she was entitled to more property. Her claim arose solely out of her
marital relationship with Meyer. But for her marriage to Meyer, she would have no claim.
Consequently, the claim is a personal one, and Meyer’s legal expenses incurred in defending
against the claim are also personal and therefore non-deductible. Meyer argues that his case is
distinct from Gilmore because Joan’s claim to his property arose in a suit separate from the divorce
proceedings, and therefore did not arise in connection with his marital relationship. However, the
claim arose in a separate suit only because the court handling the divorce lacked jurisdiction to
rule on the validity of the antenuptial agreement. Joan ultimately filed the separate suit to obtain
support payments due to her as a result of her marriage to Meyer. Therefore, Meyer’s legal
expenses are non-deductible.

CLASS NOTES:

- Pg. 499: Not mere home-owner. Court was deferential because he has sold several
properties in the past.
- Pg 489: Basically, if it is marriage, it is personal.

Pg. 491 Problem 2

(a) No deductible if related to personal expenses such as a divorce for Payor. Tax advice
deduction allowed
(b) For Payee…If you are the recipient of the income, then that would be deductible as
codified in the regulation on Pg 1203. Tax advice deduction as well as negotiations
related to alimony or non-tax advice deduction

Berry 2002 US Tax Cases

Knudsen TCM 2007-

Topping TCM

Problem 3: 212(2) No deductible on this code. But under 212(3) only tax related advice
can be deductible

Section 183: Activities Not Engaged for Profit

Interest

I. Business
 II. Investment
III. Personal
A. Residence
B. Education

250k loan

50k down-payment

thus she has 200k acquisition indebtedness.

The FMV is 400k.

The bank will finance 80% at a lower interest rate

Thus: 320k borrowed…

Assume she paid off 10k over time, and still has 190k in acquisition debt. She refinanced to borrow
320k as its cheaper…

Then 320k-190k=130k

If she uses the 130k in substantial improvement, then that interest can be deducted.

The 1million dollars is capped btw that interest could be deductible.

Note: If something is not deductible via acquisition indebtedness… it can be deductible via home
equity indebtedness. The code gives you a cap up to 100k that allows you to use the procedures of
loans for any indebtedness secured by a qualified residence to the extent the aggregate amount of
such indebtedness does not exceed the FMV-Acquisition indebtedness = [THIS AMOUNT] has
to be capped at 100k.

Up to 100k loan interest can be deductible in taxes.

Note: If you are single you can deduct 1million cap. But if you are married you are still capped at
1million.

Student Interest/Education Loan

Work from home

Pg. 573 Problem 1:

Begin with the rental income, offset it with as much as possible with the deduction, and then

Adjusted Gross Income Section 62

Gross income - That is the total income

Deductions via Section 62 provide you with the adjusted gross income after deductions have been
minus.

Deduction Box

Then Above the Line Deduction and the Below the Line Deduction

You can sum the Below the Line Deduction and you can compare it to the standard deduction. If
the standard deduction is higher, claim that. If the below the line deduction is very low, you can
still get the standard deduction. However, if the below the line deduction exceed the standard
deduction. She can itemized the deduction of the sum of the below the line.

Above the line deduction are the only deductions you will need to keep track of.

Thus who itemized? Those who’s deduction exceed the standard deduction, which is the below
the line deduction folks.

Itemized deduction is basically the deductions that are not covered in Section 62.

Pg. 601 Problem 1: Is the deduction above or below the line?

- (a) Still deductible but it will be BELOW the line

- (b) Pg 1112 Gives you the answer. Lefthand column, it is deductible above the line
because the reimbursed above the line. Pg 1112 also notes that the employer will have the
50% hair cut but the employee does not have to report the reimbursement because it will
be noted in the above the line deduction.
o But what if you got reimbursed a certain amount and you did not need to spend it
all?
 Then you report as income and net out the expenses—and the excess is
taxable income now.
o But what if you spend more than what you got reimbursed?
 Then yes, it is now deductible, BUT below the line now.
- (e) It will be deductible but BELOW the line
- (f) no reference made to the medical deduction – thus below the line deduction
- (g)
- (h)
- (i) code section 62(a)(17)  Interest on student loans  This is deductible above the line!
Treated even better than property which is below the line
- (m) 62(a)(15)  Moving expenses is above the line deduction
- (l) 62(a)(10)  Above the line deduction for Alimony
27. In general, taxpayers should itemize their tax returns if

a. their charitable contributions do not exceed $100

b. their medical bills are less than $200

c. they pay interest and taxes on home

d. they do not pay alimony

 The answer is C…

 Why is the answer C? Look to the Code.

CHARITABLE CONTRIBUTION

Section 170(c) clearly describes only the EXCESS is deductible.

“It makes no difference that the tax payers relied upon statements made by a charitable
organization that the amount paid are deductible”  Because charitable organization do not
practice law. They are self-interested economic actors—want to induce people to give them
money. Thus, that is not any sort of reliance.

Charities are supposed to provide a written receipt. This is shown in Section 170(f)(8)  “No
deduction shall be allowed under subsection(a) for any contribution of $250 or more unless the
taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the
contribution by the done organization that meets the requirements of subparagraph (B)

If it is a circumstances is of quid pro quo Section 6115(a) applies.

Note: The most charitable contribution are made towards churches, and then education groups.

One of the most controversial issue is the fact that D of Section 170(c) states that attempting to
influence legislation and which does not participate in or intervene in of candidate of public officer.
 This means essentially you can’t go against politicians. If you dotax exemption becomes
revoked.

 Thus engaging in political activities jeopardies tax exemption to charitable organization.

 However, Trump wants to repeal (D), and not only will churches be free, but all 501(c)(3)
organizations will be free!

PERSONAL EXEMPTION: Qualifying Child & Relatives

No # games. Custodial spouse gets it.

Review the problems in the book.

STANDARD DEDUCTION

38 Sections on the Syllabus.  complete 4 topics in a DAY.