INTRODUCTION

TAX LAW V. TAX POLICY

Tax policy [2-4]

Tax policy topics Size and structure of government Who/what levies and collects taxes? How much to tax? What to tax?

o Tax base: what is being taxed (mostly income for our purposes) Behavioral responses to taxes Deficits/surpluses

Tax gap Amount of taxes that should be collected under the current law versus the amount of taxes actually collected

o The tax gap has a negative effect on taxpayer morale

Tax expenditures Congress uses the IRC to disguise spending as taxes

o Expenditures operate like subsidies

Efficiency What does efficiency actually mean?

Incidences Disguising a tax on one person as a tax on another

Tax law [4-8] Most of tax law is civil rather than criminal because the mens rea in tax cases is even hard to prove than in regular

criminal cases

Sources of tax law The Code Treasury Regulations

o Not law, but very, very persuasive authority Revenue Ruling

o Similar to a judicial opinion with hypothetical factso Essentially advisory opinionso Helpful and persuasive, but not as much as the Regs.

Private Letter Rulingso Involves real factso Helpful and persuasive, but not as much as the Regs.

Common law

Tax litigation Tax payer has three forums to chose from in bringing his case:

o Tax Court (national) Appeal as of right is in Court of Appeal for Taxpayer’s residence

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If IRS is reversed in say the 4th Circuit, the only consequence is that it cannot no longer employ that argument which they were trying to advance in the 4th Circuit. The argument is still valid in other Circuits where it has not been shot down.

Precedent is only set for people coming from that specific Circuit.o District Courts

Appeal as of right is in Court of Appeal for Taxpayer’s residence Same as Tax Court

o Court of Claims Appeal as of right is in the Federal Circuit

o …everything goes to the US Supreme Court

LEGAL ETHICS AND TAX ETHICS [8] Tax evasion v. tax avoidance

o Evasion…you are on the illegal side of aggressivenesso Avoidance…you are on the legal side of aggressiveness

AVERAGE AND MARGINAL TAX RATES [9-11]

Terminology Average tax rate = total tax/total income Marginal tax rate = percent of next dollar of income that is taxed Progressive tax = tax rate rises as income rises Regressive tax = tax rate falls as income rises Proportional tax = tax rate is constant as income rises Zero bracket = amount of money which the federal government does not tax

Ways to get progressivity Zero bracket/single rate income tax Tax brackets

o 1: brackets 1(f): Brackets are updated for inflation

In determining tax liability, refer to Rev. Proc. (p.636-638 (Bank))

Calculation Gross income = Taxable income = Gross income – (Deductions + Exemptions)

o Deductions Above-the-line Below-the-line

63(c)(2): standard deduction (p.638 (Bank)) ORo married individuals filing jointly and surviving spouses: 11,600o heads of households: 8,500o unmarried individuals (other than surviving spouses and heads of households): 5,800o married individuals filing separate returns: 5,800

63(d): itemized deductionso Exemptions

151(d): personal exemption (p.636 (Bank)) $3,700

Tax = (.1 x 17,000) + (.15 x [69,000 – 17,000]) + (.25 x [139,350 – 69,000]) + (.28 x [212,300 – 139,350]) + (.33 x [379,150 – 212,300]) + (.35 x [? – 379,150])

o 1,700 + 7,800 + 17,587.50 + 20,426 + 55,060.50 + ?

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o Example of someone with a TI beyond the last bracket MTR = 35%

o percent of next dollar of income that is taxed ATR =

o Total tax/total income More hypos (p.9-10 (Notes))

IMPLICIT TAXES [11] Taxable bonds v. municipal bonds

WHAT IS INCOME?

DEFINING INCOME [12-13]Important terminology Stock variable: value is defined meaningfully without the passage of time Full variable: value is defined meaningfully only with respect to the passage of time

o There has to be a unit of time attached Income is a full variable

o High wealth individuals often have high incomeso When we are talking about income, we are not talking about wealth

Income refers to the flow of money into someone’s account over a period of time, usually a year

Haig Simons (HS) income Y (income) = FMVc (fair market value of consumption) – ∆NW (change in net worth [wealth])

o Consumption is a full variableo Net worth is a stock variable

Y = C (consumption) + S (saving) In order to measure income in all of its forms, we have to measure everything spent plus change in your net

worth Real world problems with HS…they don’t create exceptions, but “holes in the cheese”

o (1) Realization v. Accrual Accrual…you have gotten wealthier Realization…you have turned that wealth into cash

If we focus on the realization of income, we are not really taxing the person’s change in net worth, but rather how much they cashed out

o (2) Imputed income Things that have fair market values that you have received or consumed, but do not consider taxable

o (3) Below-market sales Paying a different price for the same product This skews the FMVc variable

o (4) Leisure Leisure is often described as a consumption choice Its never in actually included though

o (5) Valuation Often difficult to determine fair market value How do you determine the FMV?

1.61-2(d)(1): if the services are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary

Defining income

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61: gross income is all income from whatever source derivedo The broadest measure of income that we can impose

Assume it is income unless the Code says otherwise Important considerations

o Substance dominates formo Under policy concerns

Vertical equity Consider whether the thing we are looking at enhances the person’s ability to pay taxes?

o If yes, then it is probably income Taxes paid should increase with the amount of income earned

Horizontal equity Two people who are substantially equal should pay the same taxes Whether something is earned by windfall or labor, it should be taxed the same

Many things are excluded from TI as matters of customo Imputed income

Almost never taxedo Some, but not all, below market sales

You have know the common law to know which below market sales are taxedo Leisure

OLD COLONY AND GROSSING UP [13-14]Old Colony Held that an employer’s payment of federal income taxes on behalf of its employee constituted income to the

employee

Grossing upo Due to withholding, it is now routine for an employer to make federal (along with state and local) tax payments on

the employee’s behalf, and yet for these payments to be included in the employee’s gross incomeo Calculation (p., 117-118 (Notes))

G = Gross Pay (employer controlled); N = Net Pay (target); t = marginal tax rate Here, G = ? ; N = 80k; t = 0.2

N = G – t(G) N = (1-t)G G= N/(1-t) = 80,000/(.8) = 100,000

o Checking your answer G – (G x t) = N

o Caveat in calculation If the gross up will send you into the next tax bracket, using the higher tax rate for it will provide you with

maximum amount necessary for grossing up

NONCASH BENEFITS

Introduction [14-15]

Includes fringe benefits Why should we tax fringe benefits?

o (1) Horizontal equity However, in practice, some noncash benefits get taxed and other don’t

It really quite arbitraryo (2) It would be unfair for those whose bosses don’t play alongo (3) Behavior would change in perverse ways if we didn’t

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Employers and employees would both have an incentive to reduce the cash portion of their salaries for the sole reason of reducing tax liability

You would not want to run a system in that way that taxes changed peoples’ behaviors Concerns about a slippery slope with regards to fringe benefits

o Everyone is going to want their benefit to be and remain tax free

Meals and lodging provided to employee [14-19]

Beneglia (BTA 1937) Room and board provided to an employee is excluded from their income, and therefore not taxable, if its provide

for the convenience of his employero Here, room and board were provided for the convenience of the employero NB finds the rule and holding wrong

But, NB suggests that the majority correctly limited the opportunity for collusion between the employer and the employee under the COE test by shifting the burden of proof away from the Service and onto them

Valuationo If dissent prevailed and room and board was TI, valuation is done by calculating the FMV of what the

employee received

119: codification of a variation of the “convenience of employer” test Meals and lodging furnished to employee, his spouse, and his dependants, pursuant to employment

o (a)(1): Meals shall be excluded from income only if furnished on business premises (not the fanciest restaurant in town)

(b)(4): Meals must be furnished to at least half of the employees for the meals to meet the convenience of the employer standard

egalitarian provision geared at preventing special treatment

“furnished” Kowalski (US SC 1977)

o Meal allowance payments to state highway patrol troopers were not excludable under 119 due to failure to satisfy the “furnished” requirement. Thus, in effect, to meet the terms of the statute, the state would need to open its own version of McDonald’s and Pizza Hut at various convenient points along the highway, rather than relying on the private sector to supply its troopers with fast food.

9th Circuit essentially disregarded this holding This discord is not unusual in tax law. Furthermore, it highlights

how tax law is aberrant in that o (a)(2): Lodging shall be excluded from income only if it is a condition of employment that you must live on

the premises (b)(1): A trier of fact may consider evidence of a contract saying that lodging is for the convenience

of the employee; however, such contract will not be determinative this is to prevent collusion between he employer and employee

o RR 71-411: Employer’s convenience is most often established by proof that the employee is ‘on call’ outside of business hours

o “employee” Exclusion is only available to employees so not to self employed but would be available to the sole

employee of a corporation even if that employee owned all shares and therefore was self employed in the practical if not legal sense (and the corp could also deduct the cost as a business expense)

Lodging furnished to certain education institution employees

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o (d)(1): in the case of an employee of an educational institution, gross income shall not include the value of qualified campus lodging

o (d)(2): Exception – cases of inadequate rent (cases when the employer charges below “reality rent” (regardless of whether it is charging FMV to others) to its employees

Paragraph (1) shall not apply to the extent of the excess of (A): the lesser of:

o (i) 5% x appraised value of the qualified campus lodging, oro (ii) the average yearly rent paid by those not favored by the university (non-

employees) non-favored yearly rent (per/month x 12)

(B): Lesser of (i) and (ii) – employee’s yearly rent (per/month x 12) o If this number is positive, this is TI

o Qualified campus lodging 119(d) applies when it is a university, and the university is providing rental apartments. However, if

you are living somewhere for the convenience of the university (the employer) – such as a RA – then 119(a) applies instead.

o Policy behind 119(d) The policy behind 119(d) is that when a university wants to provide its employees with discounted

housing, then the university has to provide that benefit to all people. If it does not provide discounts to everyone, then the employee will have to pay taxes on some level of income.

Horizontal equity Also, remember the employee is not living at the convenience of the employer here

o Calculation (p.18 (Notes)) Facts

Reality rent = 7,200 Analysis (119)

(d)(2): o reality rent = 7,200 per yearo rent charged = 200 per month (2,400 per year)o below reality rent

(d)(2)(A): lesser of:o (i): 5% x appraised value of qualified campus lodging

200k is the FMV if the unit went condo .05 x 200k = 10k

o (ii): for comparable units, what the university is charging to not favored people (non-employees)

Monthly rent = 800 Annual rent = 9,600 (800 x 12)

(d)(2)(B): employee’s rento monthly rent = 200o annual rent = 2,400

9,600 (lesser of (i) and (ii)) – 2,400 (employee’s annual rent) = 7,200o $7,200 would be included in TI

Other fringe benefits statutes [19-20] American approach to fringe benefits

o Fringes started to be provided, and the if IRS doesn’t notice or doesn’t care, then the fringes get more popular

This is a huge morale issue Loss aversion

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o People are more bummed out when they thought they had something then lost it, rather than knowing they never had it at all

132: fringe benefits Drew a line at the fringe benefits people have gotten used to received as non-taxable

o There is no commonality amongst the fringes treated as non-taxable fringe benefits apply to families – i.e., spouses and dependants

o however, the definition of family is relevant to the traditional definition of a family as required by DOMA thus, same-sex couples are excluded

(b) no-additional-cost serviceo e.g., empty seats on airplanes

letting an employee fill an empty seat is of no additional cost service to the employer the employee receives something of value, but 132 allows the employee to exclude that

from the value of their incomeo (1) “in the ordinary course of the line of business”

intended for corporations with multifaceted businesses if you are a programmer for a corporation that happened to have an airline, you

CANNOT get the free airfare dealo (j) “boys in the boardroom” provision applies

(c) qualified employee discounto as long as the employer sells something to an employee at cost

in the case of services, the Code simply institutes 20% employee does not have to include the difference between cost and retail, even though

they are receiving a benefit o (4) “in the ordinary course of the line of business”

Same as 132(b)(1)o (j) “boys in the boardroom” provision applies

(j) special ruleso (1) exclusions under no-additional-cost service and qualified employee discount fringes apply to highly

compensated employees only if there is no discrimination goes against the boys in the boardroom problem for our purposes, highly compensated means highly compensated

(d) working condition fringeo It can be excluded when it is provided by the employer as fringe benefit if an employee could have

deducted it as a business expense itself (e) de minimis fringe

o most important fringe of all does not mean it is a small fringe, it means that it is an annoying fringe

accounting for them would be unreasonable or impracticable o not about “lines of business,” about annoyance

(f) qualified transportation fringeo (1) you can exclude from your income, the costs of a

commuter highway vehicle essentially employee vans taking employees from satellite parking lots to their offices

a transit pass qualified parking, bicycle commuting -- from your income

o (2) limitations on exclusion – an exclusion shall not exceed $230 per month for commuter highway vehicles and transit passes $230 per month in the case of qualified parking the applicable annual limitation in the case of any qualified bicycle commuting reimbursement

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o this fringe is here to allow people to exclude commuting costs from their taxable income 1.61-21(b)…taxation of fringe benefits

o Valuation FMV if you can determine it If you can’t determine FMV, then there may be a safe harbor rule to turn to

Sometimes its difficult to determine FMV. So if you follow a safe harbor rule, you can avoid an IRS challenge.

o (b)(5) chauffeur services: use what the limo company paid the chauffeur

Cafeteria plans [20-21]

125: cafeteria plans Another kind of fringe benefit (a): the fact that you have a choice among benefits does not turn them into cash and make them taxable

o 132 (a bunch of isolated benefits that you may receive) v. 125 (an employer has to specify a cafeteria plan) (d): you can choose some fringe benefits from the cafeteria plan and you will not have to include in your taxable

income, but if you opt out of everything and take the cash you have to pay taxes on that income (f): inclusion by reference (anti-abused provision)

o other Sections of the Code tell you what can be included in a cafeteria plan Key examples of what can be included in a cafeteria plan

Group-term life insurance Dependant care assistance Adoption assistance Excludable accident and health benefits Elective contributions under a qualified cash or deferred arrangements under 401(k)

The idea of a cafeteria plan is to allow employees to pick and choose all, some, or none of the benefits provided by the employer

If you take all of the benefits, you will have a lower taxable incomeo So, there is no horizontal equityo But, there are psychological aspects to this

You can personalize the fringes to your own situation Employee envy

The fact that you can opt-out should allegedly reduce the element of employee envy Use-it-or-lose-it rule

o If you don’t use the whole benefit up, you just lose it This stems from an incorrect estimation of what you may need in a flexible spending account

People go in for all kinds of unnecessary medical procedures on March 30 or 31o To cure these problems, NB suggests that Congress simply set limits rather than attempting to prevent

people from overspending on the preferred items by raising the risk associated with overestimatingo If you don’t use it, the funds go back to the employer

The employer may pocket the excess funds Or, the employer may redistribute the excess funds across all the employees

Another Approach to Valuation [21-23]

Turner (TCM 1954) Suggests a subjective approach to valuation…incorrect

Rooney Any previous hints at taking into account subjective valuation should not be taken seriously

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Rule You want to look for objective manifestations of value

o Important distinction Opinions and the like can affect fair market value if people put their money where there mouth is What we don’t want to do is take into account people’s unique situations

Windfalls and perks [23]

Treasure trove 1.61-4: treasure trove, to the extent of its value in US currency, constitutes gross income for the taxable year in

which it is reduced to undisputed possession If you gave back such a windfall immediately, as in the case of the record-breaking home-run balls, you are treated

as if you never possessed it at all. There is a realization requirement for found treasure.

o Only when you sell it and turn it into cash are you taxed on it. HS income but not taxable income.

IMPUTED INCOME Benefits that are not part of a commercial transaction and are therefore generally not thought of as income for

tax purposes are generally not included in a TP’s taxable incomeo Though failure to include them results in problems of fairness and economic rationality

Property (other than cash) – increase in value of a house is not taxed so long as it is unrealized and if passed at death with a stepped up basis will never be taxed and so the investment will escape taxation shows a congressional preference for home ownership and that tax system will influence actions

Services – the benefit of the services that one performs for oneself is not taxed Physic income and leisure – there is a tax on the earnings, but not the benefit of leisure that one “buys” by not

working – so there is a tax benefit to being underemployed, you can buy leisure time with pre-tax dollars

Bartering [23-24]

Rev. Ruling 79-24 Barter income is taxable Valuation

o FMV If the FMVs are different, you have to look at the FMV of what the person received in order to

decipher their taxable liability As an administrative choice, you almost always anchor the work of the thing easily valued to

the thing not so easily valuedo With a presumption for stipulated value

This value can be challenged by the IRS with affirmative evidence of their own Hypos (p.23-24 (Outline))

o Situation 1 Barter club Lawyer provides a house painter trade with legal work in exchange for the painter to paint his house Tax analysis

Lawyer values his work at $1,000o Lawyer is taxed on $500 (received)

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Painter values his work at $500o Painter is taxed on $1000 (received)

Situation isn’t normal as this is an example of a crappy deal …if the FMVs are different, you have to look at the FMV of what the person received in

order to decipher their taxable liabilityo Situation 2

A professional artist provides an owner of an apartment building with a painting in exchange for 4 months rent

Tax analysis 6 months worth of rent…FMV easy to find piece of unique art…FMV not easily found As an administrative choice, you almost always anchor the work of the thing easily

valued to the thing not so easily valuedo This becomes even more difficult when you have two things that are not easily

valued. Then, you just hire and appraiser.

6045 Requires information reporting by any “barter exchange” 1.6045-1(a)(4): the term barter exchange does not include arrangements that provide solely for the informal

exchange of similar services on a noncommercial basiso The IRS does not want to get into trivial matters, even if they are HS income.o This sometimes applies to trivial matter with commercial bases as well.

WINDFALLS AND GIFTS

Punitive damages [24]

Glenshaw Glass (US SC 1955) The Court holds that punitive damages are includable in taxable income

o Nothing limits the definition of gross income under 61 Punitive damages falls under “any source whatever”

SC sets super precedent (super precedent…decisions that is entrenched and if changed would be a big deal)

o Income has never been limited before

104(a)(2): personal injury recoveries Compensatory and punitive damages are excluded from taxable income when it is a personal injury case

o Even though they are HS incomeo Theory…all you are doing is making someone whole

But, this doesn’t really draw a distinction to the GG case Mental or psychological injuries are not covered, just physical injuries

Gifts [25-28] Income is not limited, except for exclusions, etc. Gifts are another type of exclusions

102: gifts and inheritances (a): Gifts are excluded from taxable income (b): you can exclude the initial gift, but not any income you derive from that gift

o e.g., if you get stock dividends as a gift Example (p. 25 (Notes))

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o Donna 100k Edward 30k (a) 70k GI Donna; 30k GI Edward

E provides non-personal services to Do I.e., anything that looks like a business expense

(b) 100k GI Donna; 30k GI Edward E provides personal services to D

o E.g., E cooks for D Personal expenses are not deductible from income

(c) 100k GI Donna; 0 GI Edward…allowed by fed income tax Gift as long as transfer is a “gift”

o Precisely because E did not work for D E works, in some degree, in each of the other two situations

Defining “gift” (this is the hard part) Duberstein (US SC 1960)

o Factors (1) “Detached generosity”

Detached and generosity seems to be an internally inconsistent phrase (2) “Affection, respect, admiration, charity or like impulses”

At least the court is getting somewhere here The transferor has to feel “happy”

(3) Transferor’s “intention” The stance of the recipient is irrelevant to determining whether it is a “gift” for income tax

purposes “Gift” determination does not rest on the donor’s conduct, but rather his intention

o Objective/subjective test We are reading their mind to get an objective determination of the donor’s subjective intent Court will not look to language expressing that a “gift” is a gift as outcome determinative Court will look at the totality of the circumstances Whether a gift is from employer to employee is relevant, but will not determine the court’s

outcome Whether a gift is given by a corporation is relevant, but will not determine the court’s outcome Whether a gift is deducted is relevant, but will not determine the court’s outcome

o Gifts defined as “gifts” are excludable in the recipient’s tax income o Standard for gift cases in the future

If there is an appeal, anything short of “clearly erroneous” we lead to an affirmation “Clearly erroneous” is highly deferential to triers of fact…wrong because legal finding

seems to be getting the standard of review afforded to factual findingso Pertains to facto Trial courts can handle these kinds of situations better than appellate courtso Reasonable minds could defer

Congressional action (post-Duberstein) 102: gifts

o (a): Gross income does not include the value of property, acquired by gift bequest, devise, or inheritanceo (c): value of gifts from an employer to an employee is not excludable from taxable income

this is about gifts to employees from companies In these situations, the employer may deduct the value of the gift and the employee must

include the value of the gift in his income.o We just treat such a gift as compensation.

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274(b): businesses are not allowed to deduct expenses for gifts to individuals to the extent they exceed $25 (defines ‘gift’ by reference back to 102)

o this is about gifts to individuals from companies This standard governs the Duberstein situation

If business gift, the business can deduct no more than $25. The recipient, however, may exclude the entire value of the gift from his income.

o This disincentives business gifts. If not gift, and is instead determined to be an ordinary and necessary business expense, it is

deductible to the gift giver under 162. For the receipt, however, the value of the gift is includable in their income.

The determination of a gift for one party would hold true for the other party as well.

Further defining “gift” Harris

o A person is entitled to treat items from lovers as gifts as long the relationship consists of something more than specific payments for specific sessions of sex

to treat it as a gift, you could arrange for sex on a non-transactional basis In the case of married couples, taxability of transfers of money does not hinge on the application of the

“detached and disinterested generosity” test of Duberstein

Tips and unusual gifts [28-29] Tips

o 1.61-2(a)(1): a tip is included in taxable income because it is compensation for services With regards to Duberstein, the unusual nature or unique motives of a tip may cut in favor of counting it as a

“gift,” rather than if the tip was just generally provided as additional compensation for the given transactiono But it also may not cut that way

Tipping a minister for performing a wedding; minister must include in TI Gamblers who tip out of compulsion or superstitution: dealers/servers must include in TI Scholarships: excluded from TI Surviving spouses – payments from corporations to surviving spouses [5 factors to determine if it’s a gift] (1)

payments made to wife and not to estate,; (2) no obligation of corporation to pay anything additional; (3) corporation derived no benefit from payments; (4) wife performed no services for corporation; (5) services of husband had been fully compensated

RR 76-144 – Traditional welfare payments and other government payments are generally not excludable under 102 but rather not within the contemplation of income under 61

Bonus -- starting with most likely to be included as income (1) regular bonus from employer, (2) irregular bonus from employer, (3) regular bonus from 3rd party, (4) irregular bonus from 3rd party

Transfer of unrealized gain by gift while the donor is ALIVE [30-32] Taft (US SC 1929)

o Donee has to pay tax on entire realization even though some of it was “earned” before she go the property – both because the law is clear and because the receiver of a gift is still better off

Donee assumes the place of his predecessor Carryover basis

o Threshold issue: Is the property you are receiving a gift?o 1015(a): basis of property (not cash) acquired by gifts

you go back to the last person who paid money for the property that you are getting as a gift future gain…carryover basis (you use what the original purchaser paid for that property) future loss…FMV at the time of the transfer

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This rule somewhat clumsily limits carryover loses and accompanying strategic tax moves

o Calculation example (p. 31-32 (Outline)) Original owner paid = $1500 FMV at transfer = $1000 (1) Recipient sells for $800; income = 800 (sale) – 1000 (FMV at transfer) = - 200 ($200 loss can be

subtracted from his income) Loss calculation (negative value when you subtract FMV)…subtract money from taxable

income (2) Recipient sells for $1600; income = 1600 (sale) – 1500 (carryover basis) = + 100 ($100 can be

added to his income) Gain calculation (positive value when you subtract carryover basis)…include money in

taxable income (3) Recipient sells for $1200

carryover…1200 (sale) -1500 (carryover basis) = -300o no gain

FMV…1200 (sale) -1000 (FMV) = +200o No loss

Neither loss nor gain calculation (negative value when you subtract carryover basis AND positive value when you subtract FMV)…thus, no tax consequence

o Policy behind carryover basis rule Gain side…progressive rule

You are giving away something of value, and also ridding yourself of a potentially large tax liability

Giving it away does lose you money, but some people make tax motivated citizens One of the things that this does encourage is downward distribution of wealth

Prevention of losses side…regressive rule A poorer person may transfer gifts up to a wealthy person in order for the wealthier

person to avoid tax liability o Not a policy generally espoused by Congress

Hypotheticalo 100k loss in real estateo May transfer this losing property to a wealthier person who would like to be able to

deduct the amount of the “gift” from his GI …1015 does not force transfers of wealth to just the poor

o incentive to move assets in the right direction is removed The hole…no gain or loss

o Remember: 1015 ONLY applies to gifts, so if there is an arm’s length transaction, the person receiving the property will take basis based on FMV rather than donor’s basis – so if shares were transferred as compensation, the basis would be FMV and payer would pay tax based on “sale or disposition” of property

Transfers of unrealized gain by gift at death [32-35] Threshold issue: Is the property you are receiving a gift? 1014 (a): basis of property acquired from a decedent

o (1): basis of property is stepped up (or stepped-down) to the FMV of the property at the date of the decedent’s death (2032 provides an optional valuation date of six months after death)

Way different from carryover basis Much more favorable Example

o 1m at decedent’s deatho 1m when you received it

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o you sell at for 1m the next day, then taxable income is 0 Policy

o If you hold onto property long enough there will not be income tax liability on the gain 1014 creates an incentive to hold on to property and not sell it

probably not a good way to distribute wealth Estate tax comes in to compensate for this lack of taxable income

o Estate tax When a person dies

you tax the value of their propertyo take out the expenses of dyingo take out charitable gifts directed by the estateo take out $5m zero bracket

When the first spouse dies, the estate can be transferred to the surviving spouse tax free

When the second spouse dies, the estate can be transferred to beneficiaries with a $10m zero bracket

Marginal tax rate = 35%o Policy rationales for an estate tax

(1) Highly progressive Only high-wealth people pay it Satisfies vertical equity in spades

o Only those capable to pay it do so (2) If you collect money from this tax, you don’t have to collect as much from other taxes

The estate tax allows you have lower rates on income, allows you to have 1014, etc. (3) Estate tax serves as a back-up tax on capital gains

estate tax indirectly taxes capital gains that 1014 would let go untaxed forever (4) Encourages gifts to charity

charitable gifts taken out of an estate are not subject to estate taxes

ANNUAL ACCOUNTING AND ITS CONSEQUENCES

Rules created by Congress over the years to get you out of arbitrary situations

Sanford and NOLs [35-38]

Sanford (US SC 1931) Income tax system uses annual accounting rather than transactional accounting

o Court gets the law right even though the result is unfair Big policy argument

o Any government is going to have to collect income on a regular basis in order to meet revenue requirements

NOL (net operating loss) carryovers Cured Sanford problem stemming from the unduly drastic consequences of taxing income strictly on an annual

basis Essentially a business provision Allows you to use extra losses to offset income in other years

o NOL can be carried 2 years back, 20 years forward You continue to offset your gains until you offset all of your losses

We are talking about net operating losseso Operating losses are different from capital losses

Operating losses are net profit from the business

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172: net operating loss deduction o (b)

(2): the loss must be carried back to the earliest year possible… start as far back as possible and work your way forward

(3): allows choice to only go forward and not carryback (but then you can’t carryback for any year)

o (d) (3): when computing NOL deduction you cannot include deductions from personal exemptions (4): non-corporation…when computing NOL deduction, then you cannot include non-business

deductions “trade or business” never defined by the Code

Calculationo 2009: 40k taxable incomeo 2010: -41k TI

60k salary -80k business loss -6k personal exemptions

o (d)(3) knocks out the 6k -15k nonbusiness itemized deductions

o (d)(4) knocks out the 15k No tax liability The business loss takes him into the negative (and thus the zero bracket) for taxable income He would like to carryback or carryover

He can only carry the 20k of the 41k because 172 disallows carrying the 6k or 15ko However, he can use the 6k and 15k in 2010

However, they do him no good cause he is already in the negative (way in the zero bracket)

The 21k in deductions is essentially gone So, only 20k is his NOL for 2010

o What is his strategy? Allowed strategy

(1) You can go back to year -2 then follow suit, ORo -2…-1…+1…+2…+20

special circumstances allow for a three year carryback (2) You can opt not to carryback to year -1 or -2, and start at year +1

o +1…+2…+20 Cannot just carry to year -1, unless you have nothing to offset in year -2

Here, Assume in 2008, he had nothing to offset

o He can go to 2009 and subtract 20k from the 40k and create only 20k in TI for 2009, OR

o He can apply it to 2011, etc.

Claim of right [38-40]

NAO (US SC 1932) You must include funds as income when you have:

o (1) legal right to the fundso (2) received the funds without restriction

Illinois Power (7th Cir. 1986)

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Custodian has no COR and thus does not have to pay taxes on the money they are holdingo However, what about the interest earned on that money?

Lewis (US SC 1951) No exception to the claim of right doctrine just because the taxpayer is mistaken about the validity of his claim to

the money (taxes paid on mistakenly large bonus which he gave back but which he had used completely as his own)

Income in earlier years, loss in later years, court says tough luck [don’t let perfection be the enemy of the good] Amended returns used to claim a refund of overpayments but only about facts that were or should have been

known before end of earlier year AND amendment is within 3 year SOL period

1341: computation of tax where TP restores substantial amount held under claim of right income in early years that is later lost Congressional overgenerous response to inequity in Lewis…situations involving people who find themselves in

different marginal rate tax brackets in different table years Start with a deduction in the year of repayment (rather than reopening the earlier year)

o But, if deduction exceeds 3K, then the tax is the lesser of The amount determined by claiming a deduction in the ordinary manner, OR By forgoing the deduction and claiming a credit in the year of repayment for the tax that would have

been saved by excluding the item in the earlier year Essentially allows the taxpayer to reopen the earlier year except for the interest on the

overpayment o In essence, the TP may strategically decide what outcome is better for him, rather then forcing

amendment in the year where funds were included in the income Depends on what year’s rates are higher

1341 applies ONLY to those items to which it appeared that the taxpayer had an unrestricted right in one year and to which a repayment is made in a later year because it was established after the close of the earlier year that the taxpayer did not have unrestricted right to the funds

1341 does NOT apply to restorations based on mere errors or on subsequent events (refunds pursuant to K rights), or to repayment by an embezzler of stolen funds

Tax benefit rule [40-41]

Situation: wrongly taken deduction that you may have to later includeo Took a deduction for a perfectly legitimate reason under your understanding of the facts at the timeo Later, you discovered the facts were not as you thought and you were not eligible for the deduction

111: recovery of tax benefit items If (or to the extent that) a deduction did not reduce the TP’s tax liability for any year AND any loss carryovers

resulting from it have expired without being used, the recovery of the amount deducted need not be included in income. (i.e., if you are already in the zero bracket, the deduction you wrongly took did you no good…really if it didn’t shift your brackets in any way it did you no good)

o But, if you got any benefit, then you have to include it as income If valuation is difficult you can include it to the extent you deducted it, even though this ignores

inflation Safe harbor: the exact dollar amount you wrongly deducted in the first place is what you

later include

Summary of ruled created by Congress over the years to get you out of arbitrary situations [41]Claim of right The way you choose the year in which you have to include income is on the basis of the two prong test

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NOLs You have losses in one year that aren’t helpful in one year and you want to carry them over to other years

o Fixing Sanford problem Even with NOLs, there is no transactional accounting

Tax benefit rule How to deal with a situation in which you had deduction first and income later

1341 How to deal with a situation in which you had income first and lost it later 1341 is an overgenerous response to Lewis

Recap We have considered timing issues and Congress’s as hoc responses

LOANS AND DISCHARGE OF INDEBTEDNESS

Equity v. debt Bond

o Generic term for debt in the financial world is bonds Buying a bond = lending money Selling a bond = borrowing money

Secured v. Unsecured; Recourse v. Nonrecourse

Loans [42-44] Rule

o When you take out a loan, even though you have money coming in, because it has an offsetting liability, you do not need to include that money in your income.

o When you pay back the loan, you do not deduct the payments that you make Interest payments are taxable income to the lender

o In this way, a loan operates as a savings accounto Principal is not income

Are interest payments deductible for borrowers?o Interest payments on loans are deductible to business but not individuals

Policy Congress decided Americans were spending too much money and getting into too much debt

Discharge of indebtedness [44-50] “cancellation of debt” = “discharge of indebtedness” Discharge of indebtedness income (DOI income) becomes relevant when loans are not paid back

o We trust that you are going to pay back the loan until we decide that we cannot trust you KEY…The driving factor in determining DOI Income is whether the principal loan is paid in

full 61(a)(12)

o “income from discharge of indebtedness” if a debt is discharged, then the borrower essentially has received income equal to the amount of the

indebtedness

Kirby Lumber (US SC 1931) D did not have to pay tax when they sold bonds because it was a loan, but when bought back bonds at lower price

it was DOI income and thus taxable income

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Discharge of indebtedness income really is incomeo Income is included in the year of the discharge, not the year of the loan

108: income from discharge of indebtedness Congressional cure to KL (a)(1):

o (B): if you net worth is negative then you are insolvent, and if you are insolvent you do not have to include discharge of indebtedness income in your taxable income

o (C): you can be a farmer who is not in bankruptcy and who is not insolvent, and you do not have to include discharge of indebtedness in your income, so long as the farm indebtedness qualifies

Congress loves farmers (d)(1): for the purposes of 108, “indebtedness of taxpayer” means any indebtedness:

o (A) for which the TP is liable, ORo (B) subject to which the TP holds property

(e)(5): purchase price adjustmento after the fact, we act as if the price was differento in the very limited situation in which the person you bought the good from also financed the loan, the

amount which you settle the loan for in not considered DOI Income (f)(2): excludes cancellation or repayment of student loan that is made contingent to work on charitable or

educational institution

Zarin (3rd Cir. 1990) Law is clear that D should have had to pay taxes on DOI, but that is too inequitable for court and so they find ways

around ito 61 includes DOI is income, but 61 does not define indebtedness and so court looks to 108(d)(1) which refers

to a charge on which the taxpayer is liable or subject to which the taxpayer holds property and finds D satisfies neither of these

o Court finds the gambling chips were a method of accounting rather than propertyo The debt was so large as to be unenforceable under NJ law, so court finds that the taxpayer is only liable to

the extent of the court settlement and therefore the settlement can’t represent DIO Since D was not be held liable on larger amount, reducing amount was not DOI Chips were medium of exchange, and evidence of indebtedness since they don’t have any

economic value outside the casino (since any other reading would give casinos a right to print money privately)

o Contested liability doctrine If a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute

would be treated as the amount of debt cognizable for tax purposes and any excess over amount determined to have been due is disregarded for both loss and debt accounting purposes (judicially created). This particularly involves situations concerning illiquid damages.

This serves as a washout tool because when you pay the debt on which is settled and looked to, there is no DOI income because you paid the exact amount now considered to be the debt.

o This is no proper here because it would essentially read DOI income out of the Code.

o 165(d): wagering losses…GAMBLING

o 1.165-10: You pay taxes on net winnings, but you cannot deduct net losses You can only use losses to offset winnings, however you cannot make deductions for additional

losses The IRS has ruled on comps and the Tax Court has said the taxpayer can offset the

comps as if they are winnings from gambling.o Comps are considered gambling income.

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Gambling income can be offset by gambling losses.

GAIN ON HOME SALES [50-55]

Old rule 1034 – If income on sale of home, taxpayer can exclude that income if she buys a home of greater or equal value

within 2 years 121 – At age 55, one one-time 125k exclusion, even if not used to buy home of greater or equal value within 2

years Policy for this rule

o Government was creating this new ethos of home ownershipo The path cut by Congress

Continue to buy nicer houses until you want to cash out If you continue to follow this path of owning a house – then considered the ultimate middle

class asset – then you will receive a nice exclusion

121: exclusion from a gain from sale of principal residence (b)(1): Singles

o Requirements for singles to get 250k exclusion: (1) Used home as principle residence for 2 (in the aggregate, not consecutively) of the last 5 years

o Any GAIN over 250k is taxed at 15% (b)(2): Couples filing jointly

o Requirements for couples filing jointly to get 500k exclusion: (1) either of them have owned the home for 2 (in the aggregate, not consecutively) of the last 5

years, AND (2) both of them have used it as a principal residence for 2 (in the aggregate, not consecutively) of

the last 5 years, AND (3) they are not subject to any other exceptions

o Any GAIN over 500k is taxed at 15% Reg. 1.121-1: “principal residence”

o Totality of the evidence test What you need to do is look at all of the circumstances that indicate whether it is this TP’s personal

residence Does the TP have other residences? If no, then… Where are they registered to vote? Where is the car registered? Where are the kids in school?

o You can only have 1 principal residence (c)(2)(B): “unforeseen circumstances”

o You can get a proportional exclusion if you don’t meet the above requirements, but you moved you changed your place of work, for health reasons, or unforeseen circumstances.

o What does “unforeseen circumstances” mean? “such sale or exchange is by reason of a change in place of employment, health, or, to the

extent provided in regulations, unforeseen circumstances.” Congress is trying to limit people who simply want to move prior to their two years being up

Reg. 1.121-3 Facts and circumstances test

o Safe harbors (these instances are considered unforeseen circumstances): Occupants of the house have a multiple births or single births bunched in

a two year period

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This would be a situation where you would want to move out more quickly than normally

Divorce Change in economic circumstances

o However, you do not fall under “unforeseen circumstances” when you simply want to move to another house out of preference

Private letter rulings (PLR) (not quite a powerful of authority as Regs.) Not safe harbors, but things that have met “unforeseen circumstances in private letter

rulings…o A blended family moves to some of the children’s school districto When adult child moves back in with his parentso If you need a bigger house because you have adopted kidso If a disabled parent moves back into houseo Problems with airport noiseo A child was assaulted on a school buso Narcotics officer received death threat from someone who found out where they lived

In short, we are trying to weed out people who are simply moving because they felt like movingo (c)(1)(B): “unforeseen circumstances” calculation

For a single: The shorter of:

o (1): the length of time you were in the house you are sellingo (2): The last time that you used the 121 exclusion

“bears to”o (x/250k) = (n from above/24)o exclusion =

15% tax on all income over exclusion grantedo (f): election to not have 121 apply

Sometimes you are better off refraining from applying 121Hypo 1(a) NB lives in Newark; wants to move after 19 months

o Can’t get tax break. Can he get a proportional break due to unforeseen circumstances?

o Instead of getting a 250k exclusion, he is trying to get a proportional exclusion based on 121((c)(1)(B): The shorter of…

(1)o NB moved out of his house in Newark after 19 months.o 19 months

(2)o When was the last time NB used 121? How long has it been since you used the 121

exclusion? He used 121 to exclude a gain on sale while in law school when he sold his

house there. This also was 19 months prior. You might own a house when you move into your new house, then

you might sell the old house after you moved into your new house.o 19 months

“bears to” (x/250k) = (19/24)

o 250k because NB is a single exclusion = 180k

o 15% tax on all income over 180k

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But does unforeseen circumstances apply?o Employment? No, he didn’t change schools.o Health? No.o “Unforeseen circumstances” in Regs? No.

He moved because he was bored, so he does not even get the 180k

Hypo 1(b) NB keeps his Ann Arbor house for 12 months while he’s living in Newark

o Only 3k gain on this NB still sells his Newark house still after 19 months

o Gain will be greater on Newark “Shorter of” is now 7 months

o However, if you refrain from applying the 121 exclusion to the sale of the Ann Arbor home, you still get the 19 months to apply in formulating your exclusion from selling the Newark house

Hypo 2 (re: 121(b)(2)(B)) Wilma (W) -- wife

o Lived in and owned A in 2008-2009 Harry (H) -- husband

o Lived in and owned B in 2008-2011 W lived in B in 2010 and 2011 W sells A on 1/1/11

o Gain = 350ko W excludes 250k

Pays 15% taxes on 100k remaining H sells B on 1/1/12 due to change in health

o Gain = 400k 121(b)(2)(A)

o Either spouse meets the ownership requirements? Yes.o Both spouses meet the use requirements? Yes.o Is either spouse ineligible due to the recent use of the 121 exclusion? No.

If no 121(b)(2)(A), then 121(b)(2)(B) applies:o Her use of 121 a year ago means they don’t get the whole 500k, so you run H through the three prong mill

(right above) as a single. H meets all three, so you get the full 250k

o W will only get the proportionality rule (the change in H’s health still applies because it his change in health that prompts them to sell the house)

Shorter of… Owned and used…24 months Last use of 121…12 months …calculation

o (x/250k) = (12/24) exclusion = 125k

o together, H and W can exclude 250k +125k = 375k 400k (gain) – 375k (exclusion) = 25k taxable income 15% tax on 25k

Policy effects Old rule

o If you bought a house for more than the previous house you get the exclusions, then you get the once a lifetime exclusion at age 55

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Congress didn’t want to tax gains on home so long as gains add up to post-WWII ideal of suburban life

New rule o Employs a transaction basiso Congress recognized that an across the board exclusion would inappropriately, from a policy standpoint,

give house-flippers an inappropriate tax break Congress still wants to reward middle-class homeownership, albeit not to the degree promoted by

the old ruleo Congress is limiting the benefit to deserving people… “less than 250k for a single and 500k for married”

Policy – old rule v. new ruleo Old rule

Incentive effects Caused people to buy more expensive houses each time

o The idea is that baby boomers would be growing families and were upwardly mobileo If you want to keep your tax liability at zero, go and buy more tax then you need

This would be odd if you moved from a DC apartment to Nebraska and thus had to buy a mansion to get the tax break.

You get the one time lifetime exclusion at age 55o People would wait past the time they became empty nesters and waited to move until

they were 55. …these two perverse incentives led to Congress’s production of 121

o New rule Incentive effects

Problem stemming from universal application of numbers no matter where the houseo People were engaging in tax motivated sales as their houses would hit the 250k or

500k marks This occurred in the more expensive, hot markets

o 121 was never amended for regional variation because there is no longer really big gains, let alone big regional disparities in gains due to the decline of any hot markets.

WHEN IS INCOME TAXED?

REALIZATION AND RECOGNITION [55-57]

Timing issueo A taxpayer has income, can they delay paying taxes on that income?

Even if you lost on the merits, you may be able to argue that its not taxable yet. Why do people care so much about timing? There are several reasons for wanting to defer payment of your taxes

o (1) Taxpayer is hoping for a change in rate In this way, it is a gamble that Congress will lower the tax rates

So this is a good reason to use doctrines like realization and non-recognitiono (2) Procrastination

a real, albeit not highly defensible, reasono (3) They do not have the money right now

They are either illiquid or waiting on the cash to come ino (4) As a financial matter, it is valuable to put off paying taxes as long as possible (p.40-42 (Klein))

even if you don’t think rates will change, you’re not a procrastinator, or you’re liquid… Time value of money

If you owe a certain amount in the future, planning to pay that debt through the application of interest rates from putting it in a CD, etc., will allow you

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Exampleo Tax bill = $105

How valuable is it for me to pay that tax bill a year from now rather than right now?

o Interest rate = 5%o $100 today (present value) in a bank at a 5% $105 (future value)

by not waiting the year, you are costing yourself $5 You can generalize this concept to any number of rates and any number of interest

rates Rule of 72

o Present value doubles in 72/r years r = 4%, then 72/4 = 18 years

Your present value will double with the interest rate at 4% in 18 years Because the federal government does not charge interest on legal deferrals

o So, every year you defer could earn some moneyo However, interest is charged on illegal deferrals

So, how and why do we allow deferral? Because if its beneficial to the taxpayer, it is harmful to the government…

Realization doctrine You do not have to pay taxes on HS income until you have realized the gain

o Realization usually means the sale or disposition of an asset, roughly speaking With a ton of exceptions

Why do we have a realization doctrine a part of our tax Code? (p.225, n.9)o (1) Valuation issues

A lot of property that would be subject to taxation under HS income would be very hard to valueo (2) Liquidity problems

You might have the money, but it is not in a form that you can easily cash out o (3) Divisibility of assets

You can’t just sell the fraction of a house to foot your tax billo (4) Variability

If we had a really rigid HS system, then every year you would have people doing this valuation, and frankly we have better things to do with our lives

Unrealized gains in one year may turn into unrealized losses in another year

Recognition doctrine Some situations in which you have income, and have even realized income, Congress gives you the

opportunity to opt not to recognize income and not pay taxes Why do we have a recognition doctrine a part of our tax Code? (p.247)

o (1) Liquidity problemso (2) Valuation issueso (3) Nature of the investment has not changed

gain may be realized but you took the gain and plowed it right back into something that looks identical

o (4) This is a way for Congress to give people money Congress can pass recognition rules that amount to tax breaks, but which don’t look enough like tax

breaks to get on the news

REALIZATION

Legal origins of the realization doctrine [57-60]

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Macomber (US SC 1920) US SC held that stock dividends are not to be treated as realization events

o “Income may be defined as the gain derived from labor, from capital, or from both combined.”o Creates realization requiremento Constitutional analysis (that stock dividends don’t count as income taxable w/o apportionment) has

been abandonedo Majority stated that it is not income unless the company gives him something separate that he can take

away from the company and use on her own (in essence, realization = liquidation) Even if the shareholder is the richer, its still not income

This is 180 degrees wrong according to NB Court is trying to say that it’s not realized and therefore there is no income, which is wrong, because

on these facts FMV didn’t change and so there was no income and therefore nothing to realize. Brandeis’ dissent points out loophole where form was elevated over substance and the tax outcome is based on

whether it’s called a pure dividend (not taxed) or if SH is given option to buy (dividend is taxed)o Would have been realization if corporation paid M to extinguish shares on the condition that she used the

money to buy new shares

305: modern rules on taxing stock dividends (a): except as otherwise provided, gross income does not include the amount of any distribution of the stock of

a corporation made by such corporation to its shareholders with respect to its stock (b)(1): stock dividend is taxable IF the shareholder has the option to take cash or other property in lieu of that

dividend 1.307-1(a): taxpayer’s total basis of the old shares is allocated between old and new shares based on FMV after

distribution of stock dividend

The decline of realization as a constitutional requirement [60-64]

Bruun (US SC 1940) narrowed Macomber SC held that there is indeed a realization requirement

o SC held that the cancellation of a lease because of the default of the renter is one of those non-sale realization events

Realization does NOT = liquidation (non-sales can be realization events) Realization is not limited to cash exchanges

Bruun had to pay taxes on the increase in value of the property from the new building that the leaseholder built on his land before he defaulted on the lease

109/1019: Bruun statutory aftermath Nonrecognition provisions

o You have income, but you don’t have to call it income this year 109: gross income does not include income (other than rent) derived by a lessor of real property on the

termination of a lease, representing the value of such property attributable to building erected or other improvements made by the lessee

o You can temporarily exclude the value of a building at the end of a leaseo But, to prevent abuse, you can NOT exclude value of property if building is in place of rent

1019: Neither basis nor adjusted basis will be changed based on income generated for lessor that was not taxed due to 109

109/1019: when the lease gets cancelled, technically its still a realization event, but you don’t have to recognize it.o Its still income, but you just get to put it off, until you choose to sell the land, if you ever choose to sell it.

You will pay tax on the same amount of money at some point

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But clearly you’d rather be in the tax-friendly realm of 109/1019o While this isn’t the kind of giveaway we’ve seen before, the taxpayer can surely earn

interest by delaying paying taxes 1.61-8(c)

o No safe harbors; no specificityo But, makes the rule clear

A building intended as rent has to be treated as a perfect substitute for the FMV of the annual rent, thus the realization even cannot be delayed as in the 109/1019 situation above

Applying this in real life situations will be really difficulto This is the better way to handle it, but this isn’t how we handle it. We use

109/1019. We act as if the building is not yet in the possession of the lessor and thus he

pays no income taxes on it, but also gets no deductions

Hypo 1 (p.62-63 (Notes)) Facts

o Building = 50k 10 years of life

o Annual rent = 7k per year Bruun treatment

o 1933: 50k income Gives Bruun 50k in basis (important if he goes to sell it)

If Bruun sold it a minute later for 50k, he would have no income on which to pay taxeso 1933-1943: 7k per year in rent

Building is losing 5k in value per year – depreciation Theoretically, a 1/10th of the building crumbles each year

So, he has 2k per year in income that is taxable 20k over ten years

o A total of 70k (50k + 20k) is included in his income from 1933-1943 109/1019 treatment

o 1933: 0 income gives Bruun 0 in basis in the new building (important if he goes to sell it)

o 1933-1943: 7k per year in rent Because Bruun didn’t pay taxes on the 50k when he received it, he doesn’t get deductions on

the building’s decay Bruun did not buy the building up front

So, he has 7k per year in income that is taxable 70k over ten years

o A total of 70k is included in his income from 1933-1943 Bruun will pay tax on $70k at some point

But clearly you’d rather be in the tax-friendly realm of 109/1019o While this isn’t the kind of giveaway we’ve seen before, the taxpayer can surely earn

interest by delaying paying taxes

Hypo 2 (p.63-64 (Notes)) You are the owner of the land Person renting the land puts a 400k building on it

o HS income…400k increase in net wortho Other possibilities…

Wait until year 10 The building is half used up and worth only 200k

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o Include 200k in income and take your depreciation deductions for every year after that

Acting as if the building is not in your possession for the first 10 years Here, we are pro-taxpayer

o A la 109/1019

The limits of realization: nonrecourse borrowing in excess of basis [64-65] Recourse v. non-recourse loans

o Recourse Borrower is personally liable

o Non-recourse Lender can only get whatever is secured

Lender has no access to borrower’s personal assets

Woodsam (2nd Cir. 1952) Example of a non-realization event Foreclosure is a disposition event and gain/loss would have to be realized then, however the change in the type of

loan (from recourse to nonrecourse) is not a disposition of the propertyo Despite change in loan terms, taxpayer has control of building therefore it has not been not disposed

of, therefore not realizedo Foreclosure may result in DOI income, but 108(b) has exemption if D insolvent

Contemporary understandings of the realization doctrine [65-76]

SL crisis The response of regulators to the SL crisis was to allow SLs to go ahead and gamble in the hopes that they would

get through the crisis until the interest rates come back down and the SLs become solvent again

Cottage Savings NB thinks the majority decision is awful in every respect; the dissent gets it right

o Inexplicable activism, the consequence of which is bad law, and therefore bad tax practice, which ends up resulting in people being allowed to cheat

o Aside: Duberstein

Because it provided no guidance Also bad because it said a legal finding would get the standard of review of a factual finding The consequences of bad law are bad outcomes

Zarin Bad legal reasoning

Macomber Subsequently, essentially defanged

o However, misunderstood again in CS SC

o Acknowledge that there was no sale…but was there a realizationo Whether there is a realized loss depends on a two-prong analysis

(1) There is “material difference” requirement built into the realization doctrine. 1001. 1.1001-1: “differing materially in kind or in extent”

(2) “Material difference” Distinct legal entitlements make an exchange of properties materially different

o Essentially the Court adopts the taxpayer’s argument that any difference is a material difference

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properties may very well be substantially identical, but materially different Dissent

o Majority applied form over substance

Standard going forward Establishment of a “hair-trigger” standard… any difference = realization event

o Any difference at all, under CS, is going to lead to a disposition and therefore a realization event Ever since CS, the regulators have been trying to establish a “materiality” requirement

The Regs have tried to reduce the hair-trigger standard produced by CSo Any refinancing would be a realization event

Applying CS (p.74-75 (Notes) and p.245 (Klein)))(1) J and B

o Cotton dealerso Business acquaintances

Both have cotton in a warehouse Price of cotton has fallen

o So both have substantial unrealized losses on the cotton they have in storage Both would like to avoid selling, but both have large gains and would like to avoid losses 2 ways of running the transaction

o Leaving your bale of cotton in a warehouse for storage and getting a bail back This is the non-tax, most sensible way to store cotton

o Leaving your exact bail of high-grade cotton in a warehouse for storage and getting an equally high-grade bail, albeit not the exact same one, back

Could report losses here under CS Under CS, whether there is a loss depends on how the warehouse works Question 1 suggests that there is no material difference between my cotton bail and a bail of the exact same

cotton, but its even worse as a practical matter because it will encourage people to engage in wasteful activities for tax purposes that

(2) S and J S, in NYC, has the legal entitlement to Streaker 13 and J, in Miami, has the entitlement to Streaker 14 Cars are sent to the wrong city Each dealer has the docs establishing ownership Both cars have 750k FMVs Both have a 100k basis from the down-payment Upon delivery, they now both have a 500k basis Modifications take several months J owns 13 but 14 is in his lot; S owns 14 but 13 is in his lot The sensible thing to do would be to send the papers through the mail

o But, the papers are distinct legal entitlements And because they are distinct legal entitlements, the exchange of them is a realization event

The trade of papers is a 250k realized gain for both S and Jo If they did the sensible thing, it would weirdly trip to CS rule and provide both taxpayers with a gain that

they don’t want S and J may very well go through the ridiculously wasteful process of shipping the cars rather than the paper We apply notions of symmetry here

o CS triggers a realization event in situations that aren’t beneficial for the taxpayers

NONRECOGNITION

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Introduction to nonrecognition rules [76]

Underlying incentives stemming from the realization doctrineo If people have lost money on assets, the realization doctrine gives people with losses the ability to realize

those losseso On the other hand, if you have gains, you want to hold off paying gains as long as you can by avoiding

realizing them If you can hold off on realizing gains until you die, then you have completely avoided paying

taxes on those gains Congress doesn’t like some the incentives in some of the situations created by having a realization regime…

o So, they created a nonrecognition rule

Realization v. Recognition Realization event…did something happen that looks like it is the right moment to tax Nonrecognition…you can have a realization event, but Congress allows you to delay paying taxes How to look at a given situation.

o Is there income? Income, unless you can find a special exclusionary provision inserted by Congress

o Has this income been realized?o Even if realized, is there a special rule that allows the taxpayers to defer tax for the time being?

Realizations are going to be tax events, unless you can find a special nonrecognition provision inserted by Congress

Nonrecognition rules are “giveaways”o Defers when a person has to pay taxes

This is valuable…think about the time-value of money Potential rationales for nonrecognition rules (p. 247)

o Gain should not be recognized if the transaction does not generate cash with which to pay the tax and the party is in pretty much the same business situation

Congress is deliberately creating an asymmetry, but Congress is the right organ to do so

Like-kind exchanges [77-81]

1031: exchange of property held for productive use or investment Like kind exchanges are granted non-recognition status (even when substantially different)… it is income,

and it is realized, but congress has provided for it as a non-recognition (a): no gain or loss is recognized upon exchange of property held for productive use in trade or business or for

investment solely for property of a like kind to be held either for productive use in trade or business.o Excludes inventory held for saleo Excludes financial assets easy to value and liquidate

E.g., stock, bonds Policy

o This is supposed to be a business-enhancing rule 1.1031(a)-1

o LK means two things that are darn close to the same thing LK is much broader than “substantially identical”

o Focus is on the nature and character of the property and not on its grade or quality (from Private Letting Ruling)

1.1031(a)-2o Creation of classes (p. 624 (Bank))

If you are in a like class, means you are LK

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If you are not in a like class, you might be LKo General Asset Classes (GAC)

Fairly arbitrary distinctions created by Regs. Writers Even though arbitrary, they act to provide guidance to those seeking it

Basic ruleo When defining LK, you get a vibe

Boot and basis 1031(a): pure LK exchange

o You are exchanging only LK things…nonrecognition rule 1031(b): mixed LK exchange

o If you give up a piece of LK property and receive back LK property and non-LK property and that is a gain to you, then you will have to pay tax on some of the gain, but not necessarily all of it depending on how much you got back was boot

Mixed LK exchange…some of the gain is recognizedo Shorthand

You will have to recognize the lesser of the gain or boot 1031(c): mixed LK exchange

o Mixed LK exchange…none of the loss is recognized Asymmetry between (b) and (c)

o Shorthand Losses are not recognized

But losses are easy to take advantage of because you can sell the thing rather than engaging in a LK exchange

Mixed LK exchange summary o Recognize the lesser of the gain or boot

However, losses are not recognizedo Formula (Calculations on p.78-79 (Notes))

Proceeds of the disposition Proceeds – Basis you had in property disposed = gain realized Recognized gain

Lesser of o boot received in proceeds, OR o gain realized

If gain realized is negative, do not recognize losses 1031(d): what you do with the basis after applying (b), and (c)…mixed LK exchange

o Formula (Calculations on p.79-82) A (original basis) + B (gain recognized) = C (total basis) – D (FMV of the boot) = E (new basis of

the like-kind property received)…useful equation Total basis (C)

o If you’ve recognized the gain, then you paid taxes on it, and you are done paying taxes on that income. So, we insert the gain into the basis so that you can later deduct that amount when you sell

You want to figure out the new basis because you won’t hold onto the new property forever and you’re going to want to know what basis you have in that property

How the equation comes out depends upon whether you are the payor or the payee of the boot Whether an exchange is pure or mixed depends on whether you are the payor or the payee of the boot

Sample complete calculations: mixed LK exchange problems (1) S owns Farm X and has a 10k basis in it; T owns Farm Y

o Exchange: T owns Farm X; S owns Farm Y

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S also gets 15k in cash and an 8k tractor So, there is a 23k boot

o FMVs Farm Y FMV = 100k, so Farm X FMV = 123k

This is deciphered from the 23k boot (and also assuming that this is an arm’s length transaction

o Boot/Basis Proceeds from the disposition of X

100k + 15K +8k = 123k Amount realized = Proceeds – Basis 123k – 10k = 113k

S has a 113k realized gain Recognized gain is the lesser of the realized gain or boot = 23k boot (rather than 113k realized gain)

o New Basis 10k (original basis) + 23 (gain recognized) = 33k (total basis) 33k (total basis) – 23k (FMV of boot) = 10k (new basis of the LK property received)

B = D…E remains the same (substituted basis) Basis when you sell property = 10k

(2) S owns Farm X and has a 110k basis in it; T owns Farm Y o Exchange: T owns Farm X; S owns Farm Y

S also gets 15k in cash and an 8k tractor So, there is a 23k boot

o FMVs Farm Y FMV = 100k, so Farm X FMV = 123k

This is deciphered from the 23k boot (and also assuming that this is an arm’s length transaction

o Boot/Basis Proceeds from the disposition of X

100k + 15K +8k = 123k Amount realized = Proceeds – Basis 123k – 110k = 13k

S has a 13k realized gain Recognized gain is the lesser of the realized gain or boot = 13k realized gain (rather than 23k boot)

o New Basis 110k (original basis) + 13 (gain recognized) = 123k (total basis) 123k (total basis) – 23k (FMV of boot) = 100k (new basis of the LK property received) Basis when you sell property = 100k

The basis you had in the original property was 110o The 10 in boot that you didn’t pay taxes on is made up for by knocking off 10 of

your basis (3) S owns Farm X and has a 130k basis in it; T owns Farm Y

o Exchange: T owns Farm X; S owns Farm Y S also gets 15k in cash and an 8k tractor

So, there is a 23k booto FMVs

Farm Y FMV = 100k, so Farm X FMV = 123k

This is deciphered from the 23k boot (and also assuming that this is an arm’s length transaction

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o Boot/Basis Proceeds from the disposition of X

100k + 15K +8k = 123k Amount realized = Proceeds – Basis 123k – 130k = -7k

S has a -7k realized gain…no recognized gain because it is a losso New Basis

130k (original basis) + 0 (gain recognized) = 130k (total basis) 130k (total basis) – 23k (FMV of boot) = 107k (new basis of the LK property received) Basis when you sell property = 107k

The rule says you have 7k loss that 1031 prohibits you from reaping a tax advantageo When you sell your property later you subtract 107k instead of 100k…there is your

7k loss (4) Example of when you are giving up boot, rather than receiving boot

o T owns Farm Y (100k FMV) T has 10k basis in Farm Y

o T exchanges Farm Y + 15k cash for Farm Xo Boot/Basis

Pure LK exchange for the person giving up boot…so no recognized gaino Basis

10k (original basis) + 0 (gain recognized) = 10k (total basis) 10k (total basis) – (-15k) (FMV of boot) = 25k (new basis of the LK property received) Basis when you sell property = 25 k

(5) Exam review hypo Formula

o A (original basis) + B (gain recognized) = C (total basis)o C (total basis) – D (FMV of boot received) = E (new basis of the LK property received)

Factso Y owns Greenacre

Basis in GA is 50k FMV of GA is 130k

o Z owns Redacrre Basis in RA is 10k FMV of RA is 200k

So, Z will require booto Exchange

Z gets GA + 70k in boot Y gets RA

o Z’s basis in GA 200k (130k + 70k) (proceeds) – 10k (basis) = 190k

Z has a realized gain of 190k Recognized gain is 70k (lesser of boot or gain)

Thus 70k TI here, and it is paid up front 10k + 70k = 80k – 70k = 10k

Basis = 10ko If she sells GA tomorrow (or in some time where FMV doesn’t change)…

130k – 10k = 120k TIo Y’s basis in RA

(200k – (50k basis in GA + 70k boot)) = 80k Pure LK exchange for the person giving up boot…so no recognized gain

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o Thus no TI here 50k + 0 = 50k – (-70k) = 120k

Basis = 120ko If she sells RA tomorrow (or in some time where FMV doesn’t change)…

200k – 120k = 80k TIo Coming full circle

Z is ultimately paying tax on her 190k gain Y is ultimately paying tax on his 80k gain

Timing Review [82]

Realizationo Macomber

Creates realization requirement Stock dividend is not only not realized, it is not even income

o Bruun Non-sales can be realization events Bruun is partially overridden by 109 and 1019

Particular situation involving lease ending and property coming back to the ownero Woodsam

Gives you an example of a non-realization evento (Cottage Savings)

Distinct legal entitlements, blah, blah In brackets because it has been appropriately (very) narrowed

Nonrecognition o Like-kind

Non-recognized except to extent of booto PLR

Nature or character defines what is LKo Regs.

Give you rules and examples to determine LKo Basis equation

Tells you how to adjust basis after a LK exchange

TRANSFERS INCIDENT TO MARRIAGE AND DIVORCE

Introduction [82] Current law re transfers incident to divorce

o Property v. Alimony Property (on-going financial obligations)

Treated like a gift o Property is not treated as income to the recipient and is not treated as a deduction

to the payoro Payee takes basis of payor

Alimony Not treated like a gift

o Alimony is income to the recipient and is a deduction to the payoro Payee does not take basis of payor

Child support

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Child support is not treated as income to the recipient and is not treated as a deduction to the payor since money is same as would be paid as a personal expense if living with child and not deductible

Property settlements

Transfers incident to a divorce or separation agreement [83-86]

Davis (US SC 1952) In return for the shares of stock, ex-wife entered into a divorce with D and waived all legal rights SC’s analysis

o This was a taxable event Mr. Davis’s Gain

Taxable gain = Proceeds (Inchoate marital rights = FMV of shares) – Basis in shares held by Mr. Davis

o Inchoate marital rights are equal in value FMV of the shares (re: Proceeds) You have to treat it as if she bought the shares with something of equal value

o Otherwise, it becomes problematic Mrs. Davis’s basis in the shares bargained for:

Her basis is the FMV of the shares on the day of divorceo Exchange was not a gift, so basis does not transfer…1041 cures this…

1041: transfer of property between spouses or incident to divorce Congress’s response to Davis

o It is not a gift, but by legislative fiat, it is given gift treatment Basis is transferred to recipient of property (it is no longer the FMV of the shares on the day of

divorce/transfer) (a) No gain/loss shall be recognized on a transfer of property from an individual to a spouse or former spouse (if

the transfer is incident to the divorce [defined in 1041(c) to mean occurring within 1 year after marriage ceases OR related to the cessation of the marriage]

o 1.1041-1T, A-7: a transfer of property is treated as related to the cessation of the marriage IF the transfer is pursuant to a divorce or separate instrument AND the transfer occurs not more than 6 years after the fate on which such marriage ceases

(b) In this case the transfer is treated as acquired by gift and the basis of the transferee will be the adjusted basis of the transferor

Statute makes the difference between community and separate property irrelevant Recipient of property will have to pay tax on original basis

Hypo (Calculations (p.85-86 (Notes)) H wholly buys W out of jointly owned house for 200k note

o H and W have basis of 100k in the house 1041 treatment

o H buys W out For W

200k (proceeds) – 150k (basis) = 50k (gain)o Under 1041(a)(2), the transfer is not a taxable event and she does not pay tax on

her gaino H sells house for 400k

For H Basis is transferred: H now has entirety of 100k basis

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o 400k (proceeds) – 100k (basis) = 300k (gain) [IF 121 was found applicable here, H would only have to 15% taxes on the 50k]

o tax rate = 20%o tax = .2 x 300k = 60k

H’s net gain 300k-60k = 240k

H still has to pay note 240k – 200k = 40k

o 140 Cash out (40k + 100k basis) Remember: W’s tax is 0

For W 200k note no tax

o 200k cash out (no basis) Because of 1041, the person who keeps the property and does not cash out first ends up with

the tax bill (he cashes out 140k, while W cashes out 200k) Davis treatment

o For W 50k basis Selling her interest to H for 200k note

HS income/gain is 150ko 200k (proceeds) – 50k basis = 150k (taxable gain when she leaves the house) [IF 121

was found applicable here, W would not have to pay any taxes] tax rate = 20% tax = .2 x 150k = 30k

170k cash on hand (200k – 30k)o made 200k on note

o For H 50k basis Paid 200k for her half of the house H’s basis goes up by 200k to 250k H then sells the house for 400k

400k (proceeds) – 250k (basis) = 150 (taxable gain when he leaves the house) [IF 121 was found applicable here, W would not have to pay any taxes}

o tax rate = 20%o tax = .2 x 150 = 30k

170k cash on hand (200k – 30k) had 200k in cash (400k in proceeds - 200k note (cash))

IF house is sold some time after divorce w/ proceeds to be split evenly, 121(d)(3)(B) allows a spouse who has not lived in the house for some time to use ex-spouse’s use of the property to establish use/ownership requirements

Davis treatment is equal tax treatment, 1041 is not equal tax treatment

Prenuptial settlements [86-88]

Mercer (2nd Cir. 1947) Mr. Mercer’s Gain

o Taxable gain = Proceeds (Inchoate marital rights = FMV of shares) – Basis in shares held by Mr. Mercer

Mrs. Mercer’s basis in the shares bargained for:

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o Her basis is the FMV of the shares on the day of transfer Exchange was not a gift, so basis does not transfer

Congress overruled Davis with 1041, but Congress did not overrule Mercer because the transaction occurred before marriage

o However, you can elect yourself into 1041 by specifying for the transfer of property in the pre-nup to occur after the marriage

Remember: Davis treatment is equal tax treatment, 1041 is not equal tax treatment

Basis in Davis and Mercer [88-89] Timeline

o 0…1…2….3 0 – husband buys shares

this gives husband his basis 1 – husband marries wife 2 – transfers shares to W; also, divorced 3 (not necessarily one year later) – W sells shares

o Tax-relevant transactions (1) In Y2, H realizes gain on sale of shares

We are looking at it as H sold the shares on the open market and W bought them back TI (Y2) = value of the inchoate marital rights in Y2 – basis of shares in Y0

o Value of inchoate marital rights is presumptively equal to the values of the shares themselves

This is less compelling in the Mercer case because divorce is more of an adversarial situation

Pre-nups are not as adversarial and it may very well be that this equivalence is really off

When do inchoate marital rights come into existence? Davis…year 1, when they took the vowels Mercer…not as clear as Davis

o Inchoate marital rights occur even before marriageo W signed away marital rights contractually

So, inchoate marital rights may come into existence before year one, but when exactly?

o If we can’t point to the exact moment, should her basis in transaction (2) be 0?

…TI (Y2) = FMV of the shares in Y2 – basis in Y0 (2) In Y2, W realizes income from selling her inchoate marital rights

TI (Y2) = FMV of shares in Y2 – FMV of shares in Y2o Under 1041, H’s Y0 basis is in the shares that transfer to W

But isn’t this problematic? Shouldn’t the basis be 0 as suggested above? (3) In Y3, W realizes income from stock sale

TI (Y3) = FMV of shares in Y3 – basis in Y2o Under 1041, W gets transferred H’s basis in the share from Y0

(4) … Hypothetically… In Y4, H disposes of inchoate marital rights for 0 TI (Y4) = 0 (Proceeds) – Basis (Y2)

o So is there a tax loss that H never realizeso In summation…this discussion…

Highlights tax logic Congress did a smart thing by saying that inchoate marital rights should not be viewed as

property So, considering that they are not property, we treat inchoate martial rights as gifts

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However, you still need to be aware of Mercer If the nexus of the transfer is not tied so closely to marriage, you have to make sure to define

the transfer of the gift …Key to this discussion: as a matter of understanding divorce transactions, this is what 1041

avoids (or gift transactions if not in marriage)

Alimony and child support

Aside from transfers of property, the only other transfers incident to divorce are alimony and child support Again, only applies to marriage, so DOMA is relevant

Alimony [89-90]

215/71/62: the recipient includes alimony in their income and the payor deducts it The requirements (71) to receive alimony treatment (p. 320-321(Klein))

o (1) Payment must be in cash In cannot be stocks, land, a car It can be a check

Cash means not propertyo (2) It has to be a written instrument

If there is a written instrument of divorce, you can presumptively get 215/71 treatment o (3) You can opt-out of 215/71 treatment

However, you can opt out of 215/71 treatment in such an agreement o (4) Parties cannot be living in the same household

Anti-fraud part of the Codeo (5) Payments have to end at the death of the recipient

If they don’t, then apparently they weren’t alimonyo (6) Cannot be payments for child support

62: alimony is an above the line deduction

Child support [90]

71(c): the recipient DOES NOT include alimony in their income and the payor DOES NOT deduct Alimony does not apply The custodial spouse is going to be receiving money and the divorce instrument has to say how much is for alimony

and how much is for child support Child support, unlike alimony, is not included in the income of the custodial spouse

o Child support payments are not taxable to the recipient because the recipient essentially has basis in that money

The recipient is really a pass-through that spends the money on the childreno Not taxable to the recipient because this is not a gain

Not deductible to the payoro The tax logic is that if they had not divorced he would be paying this money to support his children and that

would not be deductible These kinds of expenses are personal expenses

71(c) maintains a structure that is consistent with the rest of the Code

Excess front-loading [90-92]

71(f) Tough tax provision

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Essentially, this is a very clumsy way for Congress to make sure that substance dominates formo Remember:

There is a tax advantage to be had here (p.323 (Klein)) Most times…wealthier spouse gets the deduction and poorer spouse has to include the sum in

income Poorer spouse is a lower bracket, if not the zero bracket…so, there is a revenue loss to the

Treasury Formula (Calculations p.90- (Notes))

o Payments (numbers in ks) Y1 = ?; Y2 = ?; Y3 = ?

o Analysis (71) (13 steps) (f)(4)(B)(i): (Y3 payment) (f)(4)(B)(ii): 15k (f)(4)(B): (Y3 payment) + 15k = (f)(4)(B) (f)(4)(A): (Y2 payment) (f)(4): (Y2 payment) – (f)(4)(B) = (excess payment for Y2)

negative number = no excess payment for Y2 (f)(3)(B)(i)(I): (Y2 payment) –(excess payment for Y2) = (f)(3)(B)(i)(I) (f)(3)(B)(i)(II): (Y3 payment) (f)(3)(B)(i): [(f)(3)(B)(i)(I) + (Y3 payment)]/2 = AVERAGE (f)(3)(B)(ii): (average from above) + 15 = (f)(3)(B) (f)(3)(A): (Y1 payment) (f)(3): (Y1 payment) – (f)(3)(B) = (excess payment for Y1)

negative number = no excess payment for Y1 (f)(2): (excess payment for Y1) + (excess payment for Y2) = (f)(2) (f)(1): In Y3, payor includes (f)(2), recipient deducts (f)(2)

The point of all of this is curing the one-time payment termed alimony, but which in effect wasn’t alimony because alimony is to be received over time

o Recapture

Exam review hypo Facts

o Y1 = 75; Y2 = 35; Y3 = 10 Analysis

o (f)(4)(B)(i): 10 (Y3 payment)o (f)(4)(B)(ii): 15o (f)(4)(B): 10 (Y3 payment) + 15 = 25 (f)(4)(B) o (f)(4)(A): 35 (Y2 payment)o (f)(4): 35 (Y2 payment) – 25 (f)(4)(B) = 10 (excess payment for Y2)o (f)(3)(B)(i)(I): 35 (Y2 payment) –10 (excess payment for Y2) = 25 (f)(3)(B)(i)(I)o (f)(3)(B)(i)(II): 10 (Y3 payment)o (f)(3)(B)(i): [25 (f)(3)(B)(i)(I) + 10 (Y3 payment)]/2 = 17.5 AVERAGEo (f)(3)(B)(ii): 17.5 (average from above) + 15 = 32.5 (f)(3)(B)o (f)(3)(A): 75 (Y1 payment)o (f)(3): 75 (Y1 payment) – 32.5 (f)(3)(B) = 42.5 (excess payment for Y1)o (f)(2): 42.5 (excess payment for Y1) + 10 (excess payment for Y2) = 52.5 (f)(2)o (f)(1): In Y3, payor includes 52.5 (f)(2), recipient deducts 52.5 (f)(2)

Excess payment questions on the exam may ask for component pieces of this equation

Child support obligations in default [92-93]

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Diez-Arguelles (Tax Court 1984) 166(d): non-corporate taxpayer can deduct non-business bad debts as a short-term capital loss in the year such

debts become completely worthless. 166(b): bad debts are deductible only to the extent of the tax-payer’s basis Here, court continues to deny the deduction since there is no basis due to the fact that she had not “out of pocket”

expenseo NB thinks this is just wrong and that it has been established that she (1) has basis and (2) the debt is

hopelessly lost and unrecoverable

Perry o deduction for bad debt again not allowable, court tells taxpayer to go to congress and get it fixed there

1.166-1(c): to claim a deduction for a bad debt there has to be a valid an enforceable obligation to pay a fixed or determinable sum of money

o But, in Diez, the debt was valid, enforceable, and clearly could not be collected When the law is bad like this, you should use persuasive commentary or get professors to write a note or amicus

brief on the issue [especially in tax where you can go for a split in the law between tax court, court of claims, circuits]

HOW CAN TAXABLE INCOME AND TAXES BE REDUCED?

DEDUCTIONS (Itemized), EXEMPTIONS, AND CREDITS [93-95] When considering income, after you determine how much and when, you want to see if you can whittle down

your taxes due to the lowest amount possible Our rules on deductions, exemptions, and credits (DEC) work in such a way that people may have very

different zero brackets even if they have the same family sizeo It all depends on how they take advantage of the various DEC

Exclusion v. Deductiono Some deductions aren’t fully usable in ways that you might imagine

Phaseoutso Phaseouts…Personalized exemptions and itemized deductions are reduced as adjusted gross income

rises above certain threshold amounts As income rises, the tax benefit of something incrementally declines

o Phase-outs amount to little more than back-door increases in the marginal tax rates. But, these hidden taxes are in no way large

o The Tax Code is being changed so as that phase-outs may no longer exist in the near future Personal deduction

o In addition to itemizing or claiming the standard deduction, all taxpayers are entitled to a personal exemption deduction for themselves and for each of their dependants.

Standard deduction v. itemized deductiono You can take either the SD or the ID, but not botho From here forward, we will be considering itemized deductions…

Deductions operate like public subsidieso We have to consider under what circumstances people in this country would be willing to take on a high tax

burden…KEY RATIONALE Topsy-turvy benefit of itemized deductions

o Generally, Higher income higher marginal rates deduction is more valuable per $ regressive effect Could change this, as WI has, by making deductions into credits so that they are the same dollar

amount for everyone Flow chart (p.353)

o Gross income (61) This is NOT an exhaustive list

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Includes Explicit exclusions Implicit inclusions

o Minus Above the Line Deductions (62) Above the line v. below the line

If it is above the line, then you don’t lose it if you decide to take the standard deduction below the line

o If you are a lobbyist and you can move a deduction from below to above, you have made you clients a lot of money

Above the line deductions work the same way as exclusions from income This is an exhaustive list

These are the 20 things, that’s it…no other deduction is an above the line deduction Examples mentioned by NB (62)

(a)(2)(D): certain expenses of elementary and secondary school teachers (a)(3): losses from sale or exchange from (a)(7): retirement savings (a)(10): alimony (a)(15): moving expenses (a)(17): interest on education loans (a)(18): higher education expenses

o tuition and fees (a)(19): health savings account

o Equals ---------------------------Adjusted Gross Income (62) ---------------------------------------------------------o Minus Below the Line Deduction (either the standard deduction [63(c)] OR itemized deductions

[63(d)]) Must choose between SD and ID

SD Amounts (p.638 (Bank))o married individuals filing jointly and surviving spouses: 11,600o heads of households: 8,500o unmarried individuals (other than surviving spouses and heads of households): 5,800o married individuals filing separate returns: 5,800

NOT an exhaustive list Consists of all the deductions that are not above the line deductions

In essence, every other deduction Notice that for some itemized deductions that there are thresholds Choosing SD or ID?

Being below the line means two thingso Dealing with thresholdso Dealing with an amount of itemized deductions would that exceed the standard

deduction …always consider whether the SD would be greater than the total

amount you could deduct for itemizingo And Deduction for Personal Exemptions (151)

PE Amount = $3,700 per person in 2011 (p.638 (Bank))o Equals Taxable Income (63)

SIMPLE EQUATIONo Gross income – ATL = AGI – [(greater of BTL OR standard deduction) + personal exemption] =

Taxable Income

Exam Review Hypo Single person with 2 kids

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o Personal exemption = 3,700 x 3 11,100 total

o Standard deduction Head of household

So, SD = 8,500o Itemized deductions

Charitable contributions = 2,000 2,000 deduction

o you can take up to 50% of your adjusted GI Unreimbursed employee expenses = 8,000

7,000 deductiono 2% threshold

Mortgage interest = 1,500 1,500

o in full State and local taxes = 1,200

1,500 o in full

Medical expenses = 3,000 None

o 7.5% thresholdo AGI = 50,000

Possibilities (1) AGI – SD – PE = TI

o No itemizing (SD) 50,000 – (11,100 + 8,500) = 30, 400 TI

o Itemize if you can do better than 30,400 (2) AGI – ID (itemized deductions) – PE = TI

o Itemizing 50,000 – (11,100 + 12,000) = 26,900 TI

We go with Possibility (2)

DEDUCTIONS Below, we are dealing with all itemized, below-the-line deductions

o Aside from Section (1) Health Insurance, which is not even income

Health Insurance [95] 162: deductible for employer 106: excludable from gross income for employees Health insurance is a completely nontaxable event

o The purest subsidy you can get through the Code Examples (p.95 (Notes))

o (1) E (employee) receives

70k in salary 5k in health insurance

HS income: 75k Because of 106…

5k is excluded and 70k is her gross incomeo (2)

S (self-employed):40

75k in receipts 5k in health care expenses

o deductible under 162 GI: 70k

o (3) N (employed, but not provided with health insurance by employer):

75k in salaryo both E and N cost employer 75k a year

doesn’t matter for the business tax-wise because salary and health are both deductible for the employer

5k in health care expenseso This 5k is a huge assumption because if you are a non-covered employee looking for

health insurance, you will get nowhere near as close to the same deal GI: 75k

Medical expenses

Introduction [95-96] What about medical expenses that are NOT REIMBURSED BY ANY MEDICAL COVERAGE you may have?

262 Deductions cannot be personal, living, or family expenses except as otherwise permitted in the Code

213 (a) allowance of deduction

o You can deduct medical expenses, not covered by insurance or otherwise, for yourself, spouse, or dependents to the extent that such expenses exceed 7.5 percent of adjusted gross income.

Policy-wise, 213 is only there for extraordinary misfortune 213 is for people who have something very big go wrong that is not covered by insurance

Keep in mind, when we give someone a break on their taxes, everyone else pays So, we have to consider under what circumstances people in this country would be willing to

take on a high tax burden.o This 213 logic applies to deductions in general…KEY RATIONALE

My aside: 213 kind of works like insurance…however, the funds after the “deductible” threshold are not covered, just merely not included in income

213 creates a disincentive to purchase health insurance (b) limitation with respect to medicine and drugs

o We are talking about prescription medicine, not Advil (d) definitions

o (1) “medical care” medical care is deductible a bit of broad definition

fleshed out below (1)(A): for the disagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of

affecting any structure or function of the body (1)(B): for transportation primarily for and essential to medical care (1)(C): for qualified long-term care services, when provided by licensed health care practitioner

o (2) amounts paid for lodging lodging away from home, that is part of the medical care, is deductible you are not there for pleasure or spending money lavishly because you know it is deductible amount taken into account for each individual shall not exceed $50 per night

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o (9) cosmetic surgery “medical care” does not include cosmetic surgery unless it is performed to cure a birth defect,

an injury stemming from an accident or trauma, or a disfiguring disease RR 75-318 – the cost of Braille books was deductible over the cost of regular books RR 64-173 – deduction allowed for cost of person to walk with a blind child through the halls Regs §1.213-1(e)(1)(iii): Outlays to make a house handicap accessible, or as necessitated by illness are only

deductible to the extent they do not increase the FMV of the houseo E.g., Constructing entrance/exit ramps; Widening doorways; Modifying hallways ; Installing railing,

support bars, or other modifications to the bathroom; Lowering or making adjustments to kitchen cabinets; Installing porch lifts or other forms of lifts; Modifying fire alarms, smoke detectors; Modifying stairs; Adding handrails or grab bars; Modifying hardware on doors; Modifying areas in front of entrance and exit doors; AND Grading of ground to provide access to residence.

The rules on what constitute “medical care” are very much socially contingento While falls under “cosmetic” and therefore a little too weird to constitute a deduction for “medical care”

will change over time as different procedures become more mainstream

Health Savings Accounts Allow you to saving money for health care 223(c)(2) – deductible must be at least $1K and not more than $5K An employee that has a health care plan within this can claim tax deductible contributions to the LESSER of (1)

the amount of the deductible or (b) $2250 (self coverage)/$4500 (family coverage)o Contribution to HSAs by employers are deductible to employers and nontaxable to employee recipients

These contributions are considered an adjustment to gross income under §62(a)(19) and t/f can be claimed by those who do NOT itemize

o Deduction is also not subject AMT §233(e) – Amount earned in the accounts are not taxable §223(f)(1) – Amounts paid from the account to reimburse employees for medical expenses are nontaxable to the

employee §223(f)(2) – Amounts paid out that are not for medical expenses are taxable as ordinary income In effect this serves as a retirement account as the deduction is allowed even though amounts were left over from

prior years coupled with the broad allowable use of this money (213 term is generally broader than insurance definition) gives people an incentive to careful in incurring medical expenses because they will be spending their own money

Further defining “medical care” [96-99] Taylor (Tax Court 1987)

o Court held that TP could not deduct lawn mowing fees as a medical expense (it was a personal expense) Some factors to consider

(1) The expense is not necessarily directly tied to healthcare providers, etc. o Someone in the family could have helped

However, some things are medical expenses that don’t have anything to do with healthcare providers (consider lodging provisions)

(2) Causationo It is not clear whether “but for” his allergy he would have otherwise mowed his own

lawn Important to look to the past here

(3) Doctor recommended activities do not always constitute deductible medical expenseso TP has the burden in these situations

Henderson I (Tax Court Memo 2000-231)

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o Depreciation of the van used from disable kid will not be deductible as a medical expense because deprecation does not constitute “amounts/expenses paid”

The lift installed was deductible in itself “Amounts/expenses paid”

o When you pay an expense, money must change hands Court is saying that “amounts paid” means dollars changing hands, but this

isn’t really the case in an accounting sense (consider the change in HS income that the parents experience here)

o However, it reasonable to say that the depreciation constitutes an amount paid in that it lowers their HS income (NB thinks this case came out wrong)

OCHSo Majority dismisses this as 262 personal expenses since someone would have needed to take care of kids

even if there was no sick mother – but this ignores the fact that there IS a sick mother Majority is worried about permitting a deduction for what they view as a personal expense that also

happened to result in a medical benefit to the wifeo Dissent acknowledges that the majority is worried about a slippery slope and so proposes his own test

Would taxpayer normally spend their money in this way? Did the taxpayer buy such luxuries in the past? Did a doctor prescribe this? Did taxpayer act in most economically efficient way? Was this over and above normal living expenses? Was this closely geared to a particular condition rather than general health?

o Dissent is willing to limit the deduction to the expense to the deductible expenses to the care of the children at the time when they would otherwise be around the mother

NB agrees with the dissent

Charitable Contributions

Introduction [99-100] One of the safest bets in the world that big time tax reform efforts will never get rid of this Charitable contributions account for large sum of money, but it is not going anyway because it is considered

absolutely fundamental to American values Also, charitable contributions are highly abused

Two sides of the story for charitable contributions 170: governs deductibility of charitable contributions

o If you make a contribution to a charity, and you are itemizing, you can take the amount you give as a deduction

Charitable contributions are allowed as itemized deductions…above the lineo Any given year the maximum you can take is 50% of your adjusted gross income

But, 5 year carrover allowed Thus, another place, in addition to the medical expenses context (think the 7.5% threshold),

where adjusted gross income is importanto (b)(1)(B): if donation is principally for a private foundation it is limited to 30% of AGIo (b)(2): corporations are limited to donations of 10% of taxable incomeo (c): categories of charities

(1): governments (2): non-governmental charities

o (e)/(f): compliance provisions (f)(8): TPs who claim a deduction for any form of contribution in excess of $250 must be able to

substantiate the reduction with a written acknowledge of the donation by the donee.

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(f)(8)(D): the donee organization can alternatively file information with the IRS directly (f)(11): for contributions which are not readily valued and for which the deduction is more than

$500, the TP must include with the return a description of the property (f)(12): when vehicles are donated the deduction is limited to the proceeds of the sale

501: governs the recipients of charitable contributionso (c)(3): if you organized properly as a charity, the charitable contributions that you receive are not

taxable. 170 charities = 501 charities

o Requirements for “charity” status (1) Charitable institutions cannot privately benefit individuals from the tax-exempt status.

The private benefit is interpreted to mean “extraordinary benefit”o There is a reasonable element to this

(2) You cannot engage in electioneering You cannot engage in candidate advocacy

o But this doesn’t seem to be enforced so strictly. Contributions of Property

o The difference between long-term and short-term This is really important because the tax treatment on short-term is not very generous

Short-term: If you have held the property for less than a year, the only thing you can deduct is the basis

Long-term: If you have held the property for more than a year, you can deduct the FMV of the property.

Deductions for gifts of property that would be long term capital gains are limited to 30% of AGI (20% to a private foundation)

Policy o Way for the government to help subsidize charities

But, where do we draw the line when deciding what TPs are going to be subsidize?

Gifts with private objective or benefits: BUSINESSES [100-102] Ottawa Silica (Fed. Cir. 1983)

o OS loses deduction for charitable contribution because of the roads they expected to be built in returno Substantial benefit test

You will not be allowed to deduct if you receive a substantial benefit in return for your charitable contribution, regardless of whether the predominant purpose of the contribution was charitable abd not business-related

“substantial benefit”o Something beyond what everyone else from the supposed act of charity

It is okay for a donor to get a benefit from a nominally charitable deduction so long as long as the benefit is not uniquely beneficial to the donor

Contra e.g., you can get a deduction for donating to an anti-gang organization

o If this is really a business transaction in disguise than a deduction is not allowed o Very TP unfriendlyo What happens when OS loses its charitable donation?

Although OS loses the charitable donation, they get to take advantage of the basis The basis in the land that they gave away can now be added to their basis.

o Had the taxpayer won, it would have recognized a current deduction equal to the FMV of the contributed property. Instead, the TP received no current deduction and could only add to the basis of the contributed property to its other land. The TP would, in effect, be able to deduct that basis when and if it sold its other land.

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The effect of the government victory was twofold. First, the taxpayer was forced to defer any tax benefit for what might turn out to be many year. Second, the eventual tax benefit would be limited to the basis of the contributed property, rather than the fair market value of the contributed property. (p. 386-387 (Klein))

Duval (Tax Court)o Tax Court went other direction from OSo Predominant purpose test (predominant purpose of the donation must be for a public purpose)

(1) Intent-based (2) More than incidental

o Very TP friendly For the IRS to win a case under this test, they have to prove that the TP knew they were going

to get a benefit AND that’s the biggest reason why they engaged in the transaction. “biggest” v. “substantial”

Law from OS and Duvalo There are at least two different standards out there

(1) substantial benefit (2) predominant purpose

o There is a possibility that a business may lose its charitable deduction for engaging in a quid pro quo The two different standards explore how much self-dealing is allowed

o Businesses who take charitable deductions need to be able to prove that they did not intend to receive a substantial benefit in exchange

o All or nothing test If you fail the standard, then you lose the entire value of the charitable deduction

All you get to do is take advantage of the basis of the property given away This rule seems very harsh… (next section)

o Important aside: The deduction itself cannot be the economic benefit that disallows the charitable deduction …you need to get something beyond the tax benefit

Gifts with private objective or benefits: NON-BUSINESSES [103] The same two contrasting standard may apply:

o (1) substantial benefito (2) predominant purpose

Important distinction between business and non-businesso If a business makes a charitable contribution and gets too much benefit, then they lose the whole

thingo RR 67-246: For non-businesses, there can be a quid pro quo

The existence of the quid pro quo means you lose only the value of the thing you receive as a part of that deal

This does not exist for businesses because, as a policy matter we strongly suspect businesses as seeks profits…so we need a relatively severe regime

An OS-like rule would kill much of charitable giving, so instead we have a partial reduction rule

Non-businesses o Charity gets full advantageo Donor gets partial deduction

The deduction you get comes from the amount of your donation minus the value of the goods you received in exchange

The deduction is offset by the substantial benefit you receive in return

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o De minimis exception You don’t have to offset your charitable deduction when the only thing you

receive is very minimal (e.g., swag). One of the problems is substantiating values

o 6115 polices this by requiring that for any quid pro quo contribution over $75 the charity must provide the donor with a written statement that the entire amount is not deductible and must provide a “good faith estimate of the value of the goods or services” received.

Items below the $75 threshold are still not entirely deductible, there is simply no rule requiring charities to provide documentation

Although there are huge psychic benefits to charitable donations, the IRS does not offset the psychic benefit you get from the amount of the charitable deduction

Private charitable contributions in short Business…all or nothing rule Non-business…quid pro quo reduction rule

The special case of collegiate athletics [103] 170(I): allows for a deduction of 80% when contribution would be deductible but for the direct/indirect option to

buy ticketso NB says this is an example of law taking a backseat to politics

What is charitable? [104-Bob Jones To qualify for tax exempt status an organization must (1) fall into one of the enumerated (8) categories AND (2)

promote a general public policy of charity Revocation of charity status on public policy grounds

o Really heavy burden There has to be “no doubt” that the charity violates a “fundamental public policy”

In short, there is a public policy exception, but the reading of “public policy” is so narrow that the exception is essentially limited to the fact of BJU (race-based discrimination).

o We have to consider what the average TP would be willing to “subsidize”

501(i): disallows charitable deductions for racially discriminatory social clubs, let alone educational institutionso does not disallow charitable deductions for gender-biased social clubs

fraternal organizations wouldn’t have it

TAX CREDITS [105-106]

Deductions v. creditso The basic difference is that the value of a deduction to a TP varies depending on what tax bracket they are in

A deduction only reduces your tax income by your marginal tax rate Tax deduction is never worth more than 35 cents on the dollar

A credit is always worth a dollar You get to reduce your tax owed by that amount

Difference is further complicated by refundable and non-refundable credits Also, deductions are non-refundable

Deductions are used to reduce your taxable income; however, credits are actually used to reduce the tax itself.

o Order that you would lobby Congress: Refundable credit

Most taxpayer friendly thing we have

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Non-refundable credit Above-the-line deduction Below-the-line deduction subject to no threshold Below-the-line deduction subject to some threshold Timing rule

Two types of creditso Refundable

You get the surplus of the credit minus the tax liability that you have if that number is positive.o Non-refundable

You tax liability goes down to zero, but you do not get the surplus if there is one. Why do people have zero federal tax liability?

o You are pooro You have attained the amount of credits that has completely offset your tax liability.

32: Earned income tax credit (EITC) Refundable tax credit, does not just offset liability but also results in payments (k):

o if you do anything wrong, you will lose the ability to attain future benefits this provision is to stop cheating

The EITC is the worst of all worlds because it is the most complicated enforcement regime directed at the population least capable of dealing with this regime

The EITC is there for the working poor with kids Phase-out

o At a certain threshold, you begin to lose benefits as your income increases You can go through an income range where you are worse off for earning more

This creates a tax disincentive to work and earn more The EITC is biggest tax credit regime that we have

Tax credits, for the TP are…o Better than a deductiono Better when refundable

MIXED BUSINESS/PERSONAL DEDUCTIONS

Introduction [106-107] -

162 Allows deduction for “ordinary and necessary business expenses” paid or incurred during the taxable year in

carrying on any business or trade For individuals, limited by 67

o 67: 2% of AGI threshold For this 2% threshold you can aggregate all of your miscellaneous “ordinary and necessary business

expenses”…..KEY: AGGREGATE 2% THRESHOLD FOR “ORGINARY AND NECESSARY BUSINESS EXPENSES”

Purpose of the threshold is to avoid dealing with de minimis expenses For businesses, there is no limiting threshold

o If self-employed, no threshold It’s not really “income” if paid out of pocket for production Below-the-line deductions

o Dealing with AGI threshold

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212 Applies to individuals For “cost of producing income” 212 was added specifically for income from sources other than a trade or business

o The expenses that go along with managing an investment portfolio 212 is probably unnecessary

o 162 is the go to section in terms of business deductions Below-the-line deductions

262 No deduction allowed for personal, living, or family expenses

o We will not subsidize people’s personal expenses

Controlling the abuse of business deductions

Hobby losses [107-108]

Nickerson (7th Cir. 1983) Must be sincere, though not necessarily realistic expectation of profit 183: activities not engaged in for profit

o Deduction allowed only when the activity is engaged in for profit (but only to the extent that it exceeds 2% AGI threshold)

Determined by a facts-and-circumstances test All-or-nothing approach…you fail 183, you get no deduction

o (b)(2): expenses incurred in activities not engaged in for a profit can be deducted only to the extent that the gross income derived from such activity exceeds otherwise allowable deductions (d): profit presumption (rebuttable)

If you made a profit in 3 of the last 5 taxable years, then you are presumed to have engaged in the activity for profit

If the TP does not meet the requirements for this rebuttable presumption, he has the burden of proof, and must show a bonafide expectation that at some point you will be making a profit

o 1.183-2(b): totality of the circumstances test Some factors considered:

Manner in which taxpayer carries on activity Expertise of taxpayer or his advisors Time & Effort expended by taxpayer in carrying on the activity Expectation that assets used in activity may appreciate in value Success of the taxpayer in carrying on other similar or dissimilar activities Taxpayer’s history of income or losses with respect to the activity Amount of occasional profits, if any, which are earned Financial status of taxpayer Elements of personal pleasure or recreation

o Policy Again, we have to ask when we are willing to see the activity as business focused enough so as to

provide a “public subsidy” via a tax deduction? Holding

o TP’s activity on the farm was not for profit Court concludes that “[c]ommon sense indicates to us that rational people do not perform

hard manual labor for no reason, and if the possibility that petitioners performed these labors for pleasure is eliminated the only remaining motivation is profit.” (p. 430)

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NB thinks that court comes out wrong in reversing the trial court on this rationale

Other hobby cases McCarthy: father was allowed to deduct managing costs of 13 year old son’s motorcross racing career even though

he had no likelihood of making a profit in any particular yearo Pre-opening expense doctrine under which expenses incurred before taxpayer begins business operations

must be capitalized [unless they are a farmer] Farish: Likelihood that taxpayer engaged in business to make a profit can be considered in light of geographical

and occupational factors – breeding horses was found deductible for Texans engaged in oil drilling Daily: Trips to Europe are not deductible as a business expense when antique dealers never advertised any items for

sale, never offered anything for sale, and never actually sold an item

Home offices [108-110]

Popov (9th Cir. 2001) 280A: disallowance of certain expenses in connection with business use of home, rental of vacation homes,

etc.o (a) General rule is to deny deductions for any use of a home for business purposes

technically unnecessary with 262 but serves as a reminder that personal expenses are non-deductibleo (c)(1): Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the

dwelling unit which is exclusively used on a regular basis (a) As the principle place of business for any trade or business of the taxpayer (b) As the place of business which is used by patients, clients, or customers in meeting or dealing

with the taxpayer in the normal course of his trade or business, OR (c) in the case of a separate structure which is not attached to the dwelling unit, in connection with

the taxpayer’s trade or business (if you set up a separate structure, the Code is more forgiving, and does require that business be principle use)

...exceptions get gradually more lenient 280A(c)(1) is at issue here (where professional musician is entitled to deduct expenses for the portion of her home

used exclusively for musical practice)o Court addresses whether this deduction is allowed on the grounds that it is a home office that is exclusively

used as the principal place of business for any trade or business of the TP Solomon test

(1) Relative importance of the activities performed at each business locationo Point of performance should not determine the principal place of business o This prong is not too important to the court here

(2) Time spent at each placeo Court knows this is the money factor

Does the person spend significantly more time here than anywhere else? Take away

o Advise your client to engage in exclusive use There may be not that much left of (c)(1)(a) once your satisfy the exclusive use case

Office decoration [110-

Henderson II (Tax Court) Where 162 and 262 may apply, 262 takes priority Court finds that plants and prints in Henderson’s office were not deductible Rule

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o There essential inquiry is whether there is a “sufficient nexus” between the expense and the “carrying on” of the individual’s trade or business to qualify the expenses for the deduction under 162(a), or whether they were in essence personal or living expense and non-deductible by virtue of 262.

To receive the deduction, the expense cannot be too “tangential,” “remote,” or “incidental” in aiding in the performance of the taxpayer’s business or duties

Aside: commuting expenses are nondeductible (somewhat addressing the parking issue that the court seems to ignore)

o Commuting expenses are personal

Travel and entertainment expenses [111-114]

132 Employees are not taxed on whatever personal benefit they receive out of employer-provided business travel

o If the trip is characterized as non-business then it is treated as a form of salary and taxable incomeo The cost of employee business travel is deductible for employerso Non-business-related trip that an employer pays for is deductible to employer (along the same lines of

salary IF it meets ordinary and necessary business expense test) but is taxable to the employee

Rudolph No holding. US SC realizes that they should not have granted cert.

o Found that the trip was just a different form of compensation/income (61) and the employee cannot deduct it because it is not a business expense (162) as there was no compulsion to attend the trip

Even though the employee couldn’t deduct here, the employer can deduct the expense as if he were deducting salary

Testo Dominant motive and purpose test

Is it related primarily to business or is it personal/for-pleasure in nature? If for pleasure, the expense cannot be for business, and thus is not deductible.

o Basically 162 v. 262 1.162-2(c): Where a taxpayer’s wide accompanies him on a business trip, expenses attributable to her travel

are not deductible unless it can be shows that the wife’s presence on the trip has a bona fide business purpose. Incidental service does not qualify as a deductible business expense.

Take awayo When can you make a deduction in situations involving some degree of compulsion, but also entailing

something that an objective observer may find to be enjoyable? Very fact-specific inquiry

Danville Plywood Mirror image issue to Rudolph

o In R, we are looking at the employeeo In D, we are looking at the employer

To be deductible, an entertainment expenses must meet the requirements of BOTH 162 and 274 Statutory analysis

o 162 “Ordinary and necessary business expenses”

What does “ordinary and necessary” do in terms of modifying what a “business expense” is?o “ordinary and necessary” is read conjunctively o “ordinary and necessary” can be rare

e.g., if there is a storm and you need to rebuild the business o overall, it is a pretty forgiving test

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o 274: disallowance of certain entertainment expenses, etc. Serves to limit “ordinary and necessary” Closes a loophole to business trying to write-off entertainment expenses

If its not business, then its not a business expense (a)(1)(A)

Entertainment, amusement, or recreation cannot be deducted as a business expense unless it was “directly related” to the active conduct of the taxpayer’s business or “directly preceding or following a substantial and bona fide business discussion (including a business meeting at a convention or otherwise) that the entertainment was associated with”

o This was created to prevent situations in which there was a nominal business aspect to an vacation or entertainment excursion

E.g., Rudolph (n)

Even if you can pass muster, you can only deduct 50 percent of meal and entertainment expenses

1.274-2(c): deduction is not allowed when entertainment is intended merely to establish good willo Congress went out of their way to write 274 so as to disable expanding the legitimate part of the

business trip to cover all of the expenses related to the pleasure of the trip-goers

Noteo Buchanan could have easily deducted this if he paid the employees a bonus and afforded the opportunity to

come to New Orleans (with that money in hand) This creates a R-like inquiry

In this sense, it seems as though we are predicating form over substance o Keep in mind the compulsion faced by the “organization” man

Planning guidanceo If you’re going on a trip, make sure that there is more business than pleasure going on

Make sure you have a written-down plan

1.162-2: Traveling expenses The traveling expenses have an all-or-nothing rule Even if we determine that the overall purpose of the trip was personal, you can still take deductions for particular

items on the trip that were business-relatedo However, you do not get to deduct a portion of your travel expenses

You can only deduct the travel expenses when you can deduct all of them because the trip was found to be business-related

Thus, the all-or-nothing nature of traveling expenses rule

Lesson from Rudolph and Danville Does the pleasure element or the business element dominate?

Clothing expenses [114-115]

Pevsner (5th Cir. 1980) P tries to deduct clothing as an “ordinary and necessary expenses” The generally accepted rule governing the deductibility of clothing expenses is that the cost of clothing is

deductible as a business expense only if:o (1) the clothing is of a type specifically required as a condition of employment;o (2) it is not adaptable to general usage as ordinary clothing; AND

Objective test

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The clothing cannot be considered generally accepted for ordinary streetwearo While this analysis isn’t completely clear, it is more clear than a subjective analysiso Also, this analysis is more horizontally equitable than a subjective analysis

Tough argument to make here because horizontal and vertical equity analyses seem both cut against on another and also collapse on themselves.

Horizontal equity -- could be argued either way, that two managers who both buy clothes should either both be allowed deduction or neither should be allowed, BUT in other direction this doesn’t work because if managers are of different socio-economic classes then it’s not horizontal

Vertical equity -- lower classes will be less likely to take advantage of deduction because less likely to have specialized uniforms [seems violative of vertical equity]

o (3) it is not so worn

Nelson They focus on situation specificness

o Which the Pevsner court seems to try to avoid The deduction was allowed because the clothing worn by the cast members was support to exemplify Middle

America, even though the show was filmed in Southern Californiao i.e., cast members were not going to wear cardigans in Southern California

ALTERNATIVE MINIMUM TAX [115-117]

Income tax is only one of two parallel tax systems in the USo The other being the AMT

AMT is defined as the amount over what taxpayer would otherwise owe, so it is not one or the other, but rather both, since AMT is defined as the excess

We are only looking at Sections 55 and 56 and the individual (non-corporate) AMT The basic idea for the AMT is kind of like a flat tax

o The AMT is really close to a single rate tax Two rates

o 26% and 28% The purpose of this system is to broaden the base by taking out a bunch of things people ordinarily use to

lower their tax liabilitieso Congress realized that people with high incomes had zero tax liabilities due to preferences

To the extent the AMT is imposed based on timing, the payment is treated as a credit and can be used in later years to reduce regular tax

The AMT is set-up to take out deductions, exclusions, and accounting methods that enabled high-income people to get the incomes down to zero

Structure of the taxo Really big zero bracket

Stands in for preferences eliminated by AMT55: AMT (a)

o AMT = TMT (tentative minimum tax) – Regular tax This is your AMT only if you get a positive AMT You have no AMT liability if you get a negative AMT

o Total Tax = Regular Tax + AMT (b)

o TMT

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Big pictureo The difference between the two tax systems

The AMT eliminates a bunch of deductions, credits, and special accounting methods The question is which one’s get eliminated? … p.612

o (6) Itemized deductions Note that you still get your deduction for your home mortgage interest This is the biggest area where the AMT cuts back on things that normal

people take as deductions You lose the state and local taxes deduction You lose the deduction for interest on home equity loans You lost the deduction for certain job related outlays The deduction for medical expenses is limited to the excess over 10%

(rather than 7.5%) of AGI You also lose the standard deduction and personal exemptions

The AMT has become problematic o There are rich people still getting their incomes low by using non-AMT preferenceso There are poor people suffering due to ATM-preferences o Roots of problems

AMT is not indexed to inflation So Congress has to engage in ATM fixes

Administrative problems Hard for people to know whether they have to pay the AMT

NB sometimes calls the AMT the “enough is enough tax”o The government (and thus the citizenry) will stop subsidizing you at some point

Klaassen Ks are a family with a lot of kids because they are religious AMT Calculation

o Normal/regular tax (1994) determination AGI = 83,056 Minus Itemized deductions = 19,564

Medical expenses = 4,767 State and local taxes = 3263.56

Minus Personal exemptions = 29,400 12 personal exemptions: one for each of themselves and their 10 kids

Equals TI = 34,092 Regular tax = 5,111

o AMT determination (1) State and local taxes = 3263.56 0

56(b)(1)(A)(ii): All state and local taxes have to be added back under AMT (2) Medical expense deduction = 4,767 2076.41

56(b)(1): AMT reduces deduction for medical expenses from 7.5% AGI to 10% AGI threshold

o so, they lose 2.5% AGI (3) Personal exemptions = 29, 400 0

55(b)(1)(E): in computing the AMT, 151 personal exemptions are not allowedo 55(d)(1): instead of 151 personal exemption, the AMT provides s substituted fixed

exemption for purposes of AMT computation AMTI = 68,832 Then, you get to take out the AMT exemption amount

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Taxable Excess = 68, 832 (AMTI) – 45,000 (AMT exemption amount) = 23, 832 o 55(d): default and 2010/2011 AMT exemption amounts

(A): joint return/surviving spouse = 74,450 for 2011 (B): single (not a surviving spouse) = 48,450 for 2011

TMT = (26% and/or 28%) x 23,832 (Taxable Excess) = 6196 55(b)(i): determines whether to use 26% or 28% for individual TPs

o 26% of so much of the taxable excess as does not exceed 175ko 28% of so much of the taxable excess as exceeds 175k

AMT = 6196 (TMT) – 5111 (Regular Tax) = 1085 Positive AMT, so you have to pay it

o If negative, you don’t have to pay it Majority’s legal analysis in K

o Congressional intent Even if the TP can show legislative history pointing to the fact that this is a millionaires’ tax, what

Congress ended up doing is not at all what it intended to do The Code sections are very unambiguous and need to be taken at face value

o Constitutional arguments TP suggests that the tax infringes on their freedom to exercise their religion because it makes

additional children more expensive than they would otherwise be Court says that this statute is facially neutral, so tough luck

o For the TP to win, Congress would almost have to explicitly target the group being harmed

Court knocks this out of the park and says no constitutional problem at all Concurrence

o Pleads with Congress to solve the problems embedded in the AMT

Prosman (TC Memo 1999-87) 56(b)(1): in calculating AMTI, no deduction is allowed for miscellaneous itemized deductions and State and local

taxes, unless such amounts are deductible in determining AGI (i.e., above-the-line deductions) 56(b)(1)(E): there is no deduction for personal exemptions under 151 Also, even though the court sympathized with the lower income TPs at bar, the plain meaning of the AMT suggests

that they too are subject to it.o The AMT is not just for high income earners

Exam review Hypo H and W filed join return in 2009 TI = 100k

o Regular tax = 17,375 AMTI = 150,000

o Taxable excess = 150,000 – 45,000 = 105,000 TMT = 26% of 105,000 (Taxable Excess) = 27,300 AMT = 27,300 (TMT) – 17,375 (Regular Tax) = 9,925

o Positive AMT, so you have to pay it Total tax = 27,300 (9,925 + 17,375)

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