Federal Taxation of Individuals OutlineProfesso r Capital Gans - Spring 2013

Chapter 1

Deference and Tools of a Tax Lawyer

TOOL #1: The Code

● Internal Revenue Code of 1986 (“IRC”)○ This is the bible○ Title 26 of the USC

TOOL #2: Regulations

● Two different kinds of regulations: ○ Interpretive Regulations (§ 7805 of the Code)

■ Authorizes the Secretary of Treasury to issue regulations interpreting various sections of the code

○ Legislative Regulations ■ Regulations issued under a specific grant of authority■ Allows the secretary to create gap-filling rules because they have more

expertise. Congress says “Here’s the issue, you make the law”■ Agency is quasi-legislature

● Notice and Comment ○ If the Treasury department and IRS want to get together and issue a new regulation,

they have to issue Notice in the Federal Register with a preamble explaining the problems, concerns, and a solution (proposed regulation).

○ Invite Oral and Written comments from taxpayers and provide a deadline○ Almost all regulations are issued with “Notice and Comment”

■ Sometimes a temporary regulation can be effective immediately without notice and comment. Some people raise questions of the validity of this.

● How much deference should be given to a regulation? ○ Mayo Foundation v. US:

■ Quick Facts: Mayo clinic didn’t want to pay certain tax. Prior law was an 8th circuit decision which helped them, however, Treasury issued a 7805 regulation (Interpretive Regulation) overruling the 8th circuit. Mayo challenges this regulation. Mayo wanted the “National Muffler” standard to apply because validity would have rested on whether the regulation was “issued in the heat of litigation”.

■ Issue: What standard is applied when challenging the validity of a regulation?

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■ Held: Chevron standard. Mayo now brought Chevron into the tax world.

○ Chevron Standard ■ For Interpretive Regulations (7805)

● (1) Is the statute ambiguous? ○ If not, the analysis is over and the regulation fails.

● (2) Did the agency reach a reasonable resolution of the ambiguity?○ (Did the agency stay within the scope of the ambiguity)○ “Administrative Convenience” can play towards a reasonable

resolution.○ Whether the regulation comports with statutory construction

precedent. In Mayo, the court said the IRS followed a canon of construction that exceptions from taxability are to be narrowly construed; therefore reasonable.

■ For Legislative Regulations ● (1) [Same] Is the statute ambiguous?● (2) [Different] Was the agency arbitrary or capricious in resolving

the ambiguity?

● Regulations Trumping Precedent ○ The agency is a prosecutor and a rule maker. Gans finds this problematic.○ National Cable:

■ Held: Agencies can trump precedent, including SC precedent, UNLESS the court held that the statute was unambiguous.

● Retroactive Regulations ○ General Rule: The IRS does NOT have authority to issue retroactive regulations

UNLESS a statute says they can. People rely on the law.■ Even if the agency has the power to write a retroactive regulation, they still

can be sued for abuse of discretion.

○ In 1996, congress amended 7805 to say that regulations can only be prospective. ■ ONLY Applies to code sections enacted AFTER 1996.

● Most sections were enacted before 1996. IRS can issue retroactive regulations for these but they can still be sued for abuse of discretion.

■ Exceptions: ● § 7805(b)(3) for taxpayer abuse: IRS has the power to issue

retroactive regulations, even for section after 96’, to close down taxpayer abuse. This exception is not well tested in the courts yet.

● § 7805(b)(2) for promptly issued regulations: If the regulation is issued within 18 months of enactment of the statute, IRS can make it retroactive to the date of enactment.

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● What standard for interpreting an ambiguous REGULATION? (note statute) ○ Ex: Agency interpreting its own regulation with a brief or revenue ruling

○ Auer Deference: UNLESS agency’s interpretation of the regulation is PLAINLY INCONSISTENT with the text of the regulation, the court defers to the agency’s interpretation.

■ High standard of deference.■ Reason: They know what they meant.

TOOL #3: Revenue Rulings● A Revenue Ruling (“RR”) is an official publication by the IRS announcing their opinion on an

issue authorized by § 7805 of the code.● It’s important for a tax lawyer to know if there’s a relevant RR on point.● Issued without “Notice and Comment”● RR DO NOT get Chevron Deference

○ RR are rare now. IRS rather put it in a regulation to get Chevron deference.

● RR Deference ○ RR used to resolve ambiguity in regulation: = Auer Standard (higher than Chevron)○ RR used to resolve ambiguity in the code: = Skidmore Deference (lower than

Chevron)■ Skidmore also applies to any other form of IRS interpretation of the code

(except regulation, thats Chevron deference). Ex: briefs, etc...○ Skidmore Deference:

■ Court’s ultimate question: Whether or not this interpretation is persuasive.■ Subsidiary factors:

● (1) Was the interpretation (the RR) issued contemporaneous with the enactment of the underlying statute?

○ Versus if the interpretation his issued in the heat of litigation.● (2) Consistency: Has the agency been consistent?

○ This is the big difference between Skidmore and Chevron. Chevron doesn’t care about inconsistency.

○ Ex. In Mayo, the IRS issued a regulation to change the law that was very inconsistent, but it didn’t matter because Chevron deference is used there.

○ WHAT IF: Taxpayer friendly RR and IRS wants to abandon it ■ Lower court WILL NOT hear argument from the IRS that is contrary to their

own RR UNLESS:● They argue that the statute is UNambiguous and they got it wrong.

Separation of powers doesn’t permit executive branch to re-write congress’ unambiguous statutes.

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Overview of Deference

Interpreting Document Ambiguous Regulation Ambiguous CODE

Interpretive Regulation X Chevron 1(reasonable resolution)

Legislative Regulation X Chevron 2(arbitrary & capricious)

RR Auer Skidmore

Other/ Anything Else Auer Skidmore

TOOL #4: Private Letter Rulings

● A Private Letter Ruling (“PLR”) is a ruling that is issued privately to an individual taxpayer at their request.

○ Hypo: Client wants to do a transaction but is worried about the consequences and there is no clear answer. Lawyer drafts a letter to the IRS detailing the facts, relevant authority, and proposed outcome and asks them to rule on it

● IRS charges a user fee (can be expensive, Gans’ case charged $14,000)○ 2-3 weeks letter Gans got a phone call (after submitting request with check)-- IRS

says they are litigating in this area and does not want to say anything to prejudice the litigation.

○ If they refuse to rule, you get your money back, HOWEVER, hiring a lawyer to do this is expensive as well-- and we gots to get paid nigga.

● IRC § 6110: PLRs may not be cited.○ Still good to be used as a guideline and is a great research tool. They analyzes the

code, regulations and RRs-- does the research for you!○ They can also be used to defeat penalties. If the IRS rules a PLR in your favor but

later changed their position, the PLR may be cited to defeat the penalty.

● Privacy: Often times they contain confidential information. Since they are published rulings, the confidential information is redacted.

TOOL #5: Court Decisions● 3 Possible Courts the taxpayer can choose to litigate (forum shop)

○ U.S. Tax Court○ U.S. District Court○ U.S. Claims Court

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● U.S. Tax Court ○ National court in DC, judges from the tax court will “ride the circuit” which means a

tax court judge would come to NY to try the case.○ 19 judges on the tax court who are all tax experts.○ No Jury Trials: Judges resolve questions of fact○ Appeal: Goes to Circuit Court where taxpayer lives

○ NO NEED to pay the IRS first if going to tax court■ IRS sends a “Notice of Deficiency” which gives 90 days to file a petition in the

tax court. If filed, the IRS is stayed from seeking collection until tax court case is fully resolved.

■ This temporary relief... but must pay the IRS the interest accrued if you lose■ Most clients want to sue immediately in tax court

○ 3 Kinds of Opinions the Tax Court can issue

■ Court Reviewed Decision: Tax court judge files opinion with Chief Judge who decides its controversial and it will be reviewed en banc (all 19 judges will look at it and can concur or dissent)

● Opinion is published by official tax court reports● Has a lot of precedential effect

■ Official Opinion: Tax court judge files with Chief Judge who thinks its an important issue, but not controversial and therefore no need for court reviewed opinion.

● Also published by official tax court reports

■ Memorandum Opinion: Chief Judge looks at the opinion and theres nothing novel about the issue.

● Not published in official reports but private publishers will come and publish these opinions. (TC Memo 2011-5)

● U.S. District Court ○ Most district court judges are not tax experts○ Juries are available! (only forum for this)○ Appeal: Based on where the taxpayer lives

● U.S. Claims Court ○ Sits in DC and hears claims against the US government, such as claims for refunds.○ Less expertise than tax court○ No Jury trials○ Appeal: Goes to Court of Appeals for the Federal Circuit

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● Forum Shopping ○ Jury/Sympathy:

■ Go to district court if you want sympathy from a jury

○ Expertise:■ Tax court is full of tax experts so if the law is against you choose district or

claims court.■ If its a complex law in your favor, you may want tax court.

○ Payment:■ Don’t want to pay up front = tax court■ Pay and sue for refund = district or claims court

○ Appeal:■ Tax Ct. appeal = Federal Circuit (bound by this authority)■ District and Claims ct. appeal = taxpayers home circuit (bound by authority)■ Go where the law is in your favor

Tool #6: Legislative History● Constitution: Tax legislation starts in the house● 5 Step process● Committee reports provides rich source of information and often give examples

1) House

● House Ways and Means Committee:

○ Specialized in Tax matters / Tax Experts

○ Once approved by vote → goes to House Floor

● House Floor

○ House Ways and Committee Report: memoranda explaining what they have done, what present law is, what the problem is, why change needed, this is the change (proposal) and how it would work

■ provides those not on the committee a way to read in plain english what is going on

○ Once voted on by house floor → goes to Senate2) Senate

● Senate Finance Committee:

○ tax backgrounds

○ vote on the proposed legislation

○ Senate Finance Committee Report: what House proposed and how they feel about it, if they would modify it

○ Send to the Senate Floor

● Senate Floor

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○ votes on the proposed legislation

3) Conference Committee: If the final bill which passed the House and Senate don't agree entirely and are not entirely the same

● Both House and Senate members

● Take the bill from House and bill from Senate and find compromise

● Once agreed by vote → goes back to the House and Senate for final approval vote

● Write Conference Committee Report prior to sending it for final approval vote

4) Once approved by both houses → Sent to President

5) President● Can (but most likely won’t) write memo before approving it

Two Theories of Taxation

- Dividing up the cost of government so it can be fairly shared by members of society

1 Base Taxation on Benefits: Divide the cost of government based on how much benefit each person takes from the government [not easily calculated]

a Opposition to Benefits Theory: will end up with regressive tax systemb Regressive Taxation : higher you go on income scale, the less rate of tax you pay (the

lower your percentage would be)i Ex . $10→$100; $1 benefit = originally 10% of income → now 1% of incomeii As income goes up, your tax rate would go down ,while benefits remain the same

c Progressive Taxation : higher you go on income scale, the higher the rate of tax you pay [Our System]

d Flat Taxation : as you earn more, pay the same %

2 Base Taxation on Ability to Pay: How much ability to contribute to the cost of government does each person have this year

a what factors should be considered: medical bills, mortgage interest on house?

Tax Rate Table

Section 1 of the code: every year the IRS adjusts the table for inflation

Calculation:○ [§63 of Code] Taxable Income = (Gross Income - Deductions)○ Apply % to taxable income

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Tax Rate Schedule for 2012: Federal Tax (NEXT PAGE)

[Single] Taxable Income

Tax Rate (%)

[Calculated Tax $ for bracket]

[Married] Taxable Income

Tax Rate (%)

[Calculated Tax $ for bracket]

400k 39.6 450k 39.6

1650 35 51,650 35

215,100 33 70,983 175,300 33

95,400 28 26,782 86,650 28

51,600 25 12,900 73,900 25 18,475.00

27,325 15 4,098.75 54,650 15 8,197.50

8,925 10 892.50 17,850 10 1,785.00

Ex. $36,325.00 Taxable Income = (8,925@10%=892.50) + ( 27,325@15%=4,098.75) = $4991.25 Tax Owed

What is my Tax Bracket??Average Tax Rate = [Calculated Tax Owed / Taxable Income] * 100 Ex. ($4,991.25 Tax Owed / $36,325.00 Taxable Income ) * 100 = 13.741% Average Tax Rate

Marginal Tax Bracket:○ What is my rate of income if i take in one additional dollar??○ People more interested in Marginal Tax Braket

○ If i take in more money / expect a deduction = how much tax will i generate??○ Only get a change in tax bracket if the payer is on a breakpoint of a bracket

○ Ex. Income 8,925 + 1 $. Was all at 10%, now the addition of 1$ raised , that 1 dollar is taxed at 15%.

○ Ex. Income 8,920 + 1$. Was all at 10%, even with additional 1%, still in 10%.○ Purchasing a home could result in a lower marginal bracket, bc of the new deduction to

taxable income

Tax Policy Perspective○ Average Tax: speaking in terms of equity, is it fair to discriminate for the differences in

average between different categories of taxpayers (average of someone making 34K v. average of someone making 75k)

○ Marginal Bracket: if marginal bracket becomes too high, might disincentivise people from working / continuing to work

Progressive Rate ScheduleTheory in Support: Declining marginal utility of the dollar

○ $1 to broke ass dude means more than $1 to a rich ass dude○ 1 extra dollar to poor dude goes further than $1 to rich person who uses it to light a cigar○ utility of $1 declines as you climb the income ladder○ Tax such that everyone contributed their fair share: tax on ability to pay and so rich person

taxed more, so they feel the same “pain” as the poor person

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○ Flat Tax: would work against this principle

Arguments Against:○ Flat Tax: Simpler○ Libertarian view: my money which i earned reflects my worth, and inappropriate intrusion

to take what i am entitled to○ Progressive reply: not just “your attributes” which contributed to your wealth and

success○ Progressive Rate could stifle incentives

○ As marginal bracket goes up - will cause people to not want to work - not worth my time to work if large % is getting taken by gov

○ progressive reply: is 35% versus 20-22% really such a large amount to dissuade someone from working?

○ Feminist Argument:○ w/ joint filing: spouse 1 working and income at top of bracket; if spouse 2 starts to

work, marginal bracket of spouse 2 starts at the next bracket [could file separately though - very rare]

○ spouse 2 also incurs additional cost to enter the workforce reducing the income earned

○ Flat tax: would eliminate this issue○ Leads to Marriage Non-Neutrality: tax law in some way causing people to get married or

avoid getting married

Marriage Neutrality: Penalty / Bonus○ Width of taxable income brackets different for married ○ 10% + 15% brackets doubled [no penalty]○ higher brackets not doubled○ Causes penalty (pay more tax) / bonus (pay less tax) when deciding if you will get married

or not = non-marriage neutral○ Argument for marriage penalty:

○ Economics of Scale : when two people put income together, certain savings, one house, cost of living goes down, and increases ability to contribute to government

○ Argument against marriage penalty:○ people can choose to live together verse getting married○ discourages marriage

○ To avoid a potential marriage penalty: can continue to file separately

Couple NeutralityMathematically impossible to have a progressive tax-rate schedule and marriage neutrality and couple neutrality

○ Couple Neutrality : any couple with an income of X should pay the same tax as any other couple with an income of X regardless of how the income is distributed between the two

○ Can avoid marriage non-neutrality by file separate returns○ NO way to avoid couple non-neutrality in progressive:○ Ex. #1 earns and #2 doesn’t

○ married: joint file and gets benefit of a bigger width for tax rate○ Couple: have to file separately and keep a higher bracket, even though similar

earning distribution compared to married couple

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Chapter 2

Gross IncomeIntro

Section § 61 : Defines gross income● Gross income essentially means economic benefit

○ (Glenshaw Glass) Punitive damages was gross income. Abandoned old rule that it was income from capital or labor.

■ Now, income where there has been “an undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion.”

● A court will find that section 61 is an “all-encompassing section” (congress intended this)○ In doubtful cases, air on the side of gross income

Treasure Trove:● First Question: Is it Gross Income?? [“Economic Benefit”]

○ Rev. Rule: Someone who finds treasure trove has income○ Treasury Regulation: 1.61-14: Miscellaneous items of gross income: treasure trove

constitutes gross income for taxable year in which it is reduced to undisputed possession

● 2nd Question: Timing - When is it gross income? ○ Tax brackets change and will affect the calculation for tax owed○ Affects interest calculations which the IRS is entitled to○ (Cesarini) Purchased piano in 57’, found $4,000 in it years later.

■ Gross Income? = YES, economic benefit.■ Was it income in 57’ when he bought the piano, or when he found the cash

years later?

○ Analysis: “Reduced to undisputed possession”■ Look at State Property Laws - when rights are acquired under state law??■ Mere label provided by state statute does not change undisputed possession

- look at substantive rights● Ex. NY passes law - when you find something, you are “nominal

holder” except for true owner, and not deemed income for IRS - Substantively STILL possession even with label

○ Timing affects ability for IRS to sue Taxpayer■ § 6501: Statute of Limitations: Generally 3 years from filing date

● Exceptions: 1 SOL starts after filing date

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2 Fraud : NO SOL■ IRS has burden of proof: by clear and convincing

evidence■ Taxpayer KNEW it was income and didn’t report it /

willfully filed false return■ Civil Fraud: 75% of your tax penalty [Ex. owe $100;

75$ Penalty, Plus Interest]■ Ignorance of the law can be a defense in tax world

3 Taxpayer omits more than 25% from gross income - SOL 6 Years■ raises suspicion and gives IRS more time

Illegally Gained Income / Treasure trove / Loan● Ex: Steal $, Find $, Borrow $

○ Economic Benefit -- YES○ Count as Taxable Income?

● Regulation 61-14 : Illegally earned income is still income

● Analysis : Spectrum based on “probability of repayment”○ Thief: LOW/NO likelihood of repayment (not innocent) = Taxable Income○ Find Money: LOW/NO likelihood owner will come reclaim (innocent) = Taxable

Income○ Loan: HIGH expectation of repayment = NOT taxable Income

Taxpayer Who Disgorges Income in a Later Year (Three Choices)1 Ability for Taxpayer to amend return/request refund:

○ § 6511: Cannot file claim for refund more than 3 years out.

2 (General Rule) Allow taxpayer to take a deduction on his return when he makes the repayment

○ Deduction: don’t have to pay tax on that dollar○ Problem when marginal tax changes from year reported and year disgorged

○ Ex. 50% bracket when you paid $6000 income = $3000 tax owed; Repaid dude his $6000 but now in 10% bracket = get $6000 deduction this year but you are only in 10% bracket = ($6000 x 10%) $6000 deduction worth only $600 tax savings now.

3 § 1341 (Special Treatment): Taxpayer who reports income in previous year and disgorges it in later year, will give you a refund based upon the higher bracket in the earlier year

○ Narrow exception to general rule○ Requires more than $3000○ Does Not apply to thief's only innocent people○ Taxpayers choice: use § 1341 to get the benefit of previous tax bracket or use

deduction in current tax bracket

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Employer offers to pay employee’s federal income tax● Side Note: Employer is required to withhold some income and sends to IRS, after filing

return IRS may send refund if overpaid after deductions.● If employer offers to pay federal income tax for the employee, creates problem:

○ Counts as Additional Gross Income to employee?○ § 275 : not entitled to deduction for paying federal income tax○ Regulation 1.61-14 : If Employer pays your income tax, it still counts as gross

income.

● Fundamental Principle : If someone is paying off my bill (discharging taxpayer obligation) that is economic benefit to taxpayer and is gross income.

Ex. Two situations, same person; tax bracket 50%1 Employer pays $100k @ 50% tax = $50k tax owed → Employee keeps $50k2 Employee worth $100k → Employer pays employee $66k, and pays the 50% tax owed on the $66k to

IRS, which is $33k (Employer paying $66k +$ 33k). Employee keeps the $66k.

● FORM OVER SUBSTANCE!! [No Code Section but available IRS Argument]● Creates Inequity and Distortion.

○ Inequity : Two people doing the same thing but one is taxed & one isn’t○ Distortion: As a result of the tax law itself someone’s behavior/choice is influenced

Barter Transactions● Rev Rul 79-24 : Barter transactions constitute gross income● In reality, no mechanism for catching this and hard for IRS to deal with● Form Over Substance

Ex. Two Situations with two people1 One needs his house painted and painter needs legal advice. Agree to exchange and that value of legal

work and paint job $5k each.a Constitutes economic benefit even though it is not cash (non-cash benefit has economic

benefit nonetheless)b BOTH lawyer and painter have $5000 of benefit = gross income.

2 Painter comes to my house and paid $5k. Painter comes after payment and asked legal question which costs $5k and pays.

a Painter and Lawyer exchanged checks for $5k.b Constitutes Gross Income for both of them.

● Two people have difference in form not substance = should be taxed the same

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Purchase Price Reduction● Rev Rul 79-66: Purchase Price Reductions are not taxed as gross income● Ex. Manufacturer Rebate, Credit Card Reward Points; sometimes Frequent Flyer Miles

Ex. Buy a car and costs $20k. Told if you buy now, will get $1k check as rebate in a week.○ Getting $1k check economic benefit?○ Transaction has not created any economic benefit!○ Substance: Looks like $1k loan to car dealer for a week = NO economic benefit; $1k loan and

paid $19k for car○ Represents a Deduction in the Purchase Price = $1k rebate check NOT Gross Income [Rev

Rul 77-66]

Frequent Flyer Miles ● General Rule : Frequent Flyer Miles should be viewed as purchase price reduction and not as

income if i buy ticket and earn frequent flyer miles myself

Ex. Pay $400 for ticket and get some miles. Miles = gross income?○ Nothing more than purchase price deduction (of the bought flight) and not economic benefit,

i.e. NOT gross income

● Problems: ○ Employer buys the tickets, employee gets the miles:

■ Still Purchase price reduction but EMPLOYER is enjoying it not employee (miles are not income to employer)

■ Employee gets miles from employer, as fringe benefit■ Benefit to employee = income to employee■ HOWEVER, hard to value frequent flyer miles given to employees

● Administrative Convenience : difficulty in determining “benefit”■ 2002 Service Announcement (ANN 2012-18): Service says we are studying

employer provided frequent flyer mile issue and will get back to you - but for now don’t have to report it

○ Employee converts miles into cash!■ If the Employee can turn miles into cash it is now easy to determine the

“Benefit” = Taxable!

Ex. Spend $100, get $1 back from credit card companyAnalysis: [Economic Benefit? → Yes → Presumed Income - but rule/policy might exclude it]

1 Is this something i am getting from my own purchase?a YES: purchase price reduction = NOT INCOME

2 Is this is something i am getting from a third party purchase?a Getting Cash = YES → INCOMEb Getting Frequent Flyer Miles = Benefit but IRS said NOT INCOME (as of now)c Turning Frequent Flyer Miles into Cash = INCOME

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Bargain Purchase Price● Intend to make a transaction based on what both parties thought the true value was

○ Ex. pay $100 for a piano, find out its worth $500k● General Rule : Bargain Purchase NOT taxable now and only taxed when sold

○ Exception : Compensatory bargain purchase, TAX NOW [infra below]

● Realization Requirement (1001): Don’t have to pay tax on increases in value until you realize them (i.e. sell)

● Two Reasons why you don’t immediately tax a bargain purchase even though you have economic benefit:1 Valuation Difficulty : administratively difficult and onerous to require someone to get a

valuation on every purchase○ Much easier to get solid number once the item is sold [need solid number for

return]

2 Liquidity : Person might not have liquidity to pay tax on the purchase, might force them to sell it

Compensatory Bargain Purchase● Transaction is just structured like a bargain purchase● However, intent to compensate someone instead of paying additional salary● No sympathy for Valuation and Liquidity Issues

○ Required to do appraisal to put on tax return

● § 61-2(d) Compensatory Bargain Purchase: economic benefit is income and taxed now (not when its sold)

Ex. Giving bonus to employee, $100k Piano for $1. ○ Employee Economic Benefit (net worth increase) =$99,999○ Trying to only tax on the Bargain Element: $1○ § 61-2(d): economic benefit = 99,999 → Gross Income and Taxed

Determining if economic benefit constitutes gross income :

Lottery Winner / Prize Winner● § 74: Prizes and Awards are Taxable

● $100k lottery ticket = Windfall = Gross Income //or// Raffle Winner wins a watch● Any Reasons to exclude it?

○ Discrete Transaction : (not common) Taxable!! ○ Little Liquidity sympathy

○ Winning lottery enhances capacity to pay for the cost of government

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Find Jews (Jewelry)● Common Law: have good title in the entire world except to the true owner● Reg 61-14: Treasure Trove = Economic Benefit = income!!● Discrete Transaction: No Sympathy

○ Liquidity: lucky to find it○ Valuation: have to get appraisal for return

BaseBall● Clearly Economic Benefit - but maybe exclude?● Controversial: Buy ticket to baseball game and walk away with $100k ball - Tax Now?

○ Similar to windfall?■ Buy lottery ticket and win $100k → Windfall = Taxed Now

○ Bargain Purchase Price?■ Paid for $10 ticket and also got $100k Ball?

● Gans: More like Lottery Ticket - Taxed Now (b/c Windfall)○ Discrete Transaction - Little Sympathy

● If you sell baseball = definitely taxable income

● 1998 Service Announcement (IR 98-56): If you turn down the baseball - NO income○ Rev. Rul 66-167: If you turn down economic benefit → no income

● If you return the baseball in exchange for “gifts” from the team/owner = NOW Income!!○ Determined as if he sold the baseball for things of value and income on the sale - not

a “gift” from the team/owners○ Taxpayer wants to argue they are two separate transactions: (1) returned the

baseball so no income, (2) got gifts from team/owner○ Step Transaction Doctrine : If two separate transactions are sufficiently related, IRS

can look at is as if they are an integrated unit○ NOT two separate transactions, but returned baseball and immediately got gifts!

Self-Created (Items / Services)● Taxed when you sell it

○ Don’t want to discourage diligence○ Privacy concerns: having to report everything you do for yourself○ Valuation issues

Stock Given in Company / Free Car as incentive to take employment● Clearly Economic Benefit!● If you give the car to your Spouse?

○ STILL income - file joint return● If you give the car to your Daughter?

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○ Assignment of Income Doctrine : Income is taxed to the person who earns it and cannot shift it to anyone by assignment

■ Attempting to game the system and tax the income in daughters 10% bracket not your 35% bracket

Landlord Renting House● Get cash money = Income to landlord● Renter exchange services instead of cash (like barter transaction) = EACH getting income

equal to rental value● Renter gives services and cash to reduce the cost:

○ Landlord still has income equal to actual rental cost○ Person renting:

■ Economic Benefit = (actual rental cost) - (any cash towards rent) - (any cash he expends to perform the services)

■ The “hard work” which the renter does to perform the services doesn’t matter

Home Ownership● Income = Consumption + Savings (both get taxed in our system)

○ “consuming” income doesn’t reduce your taxable income on return

● Bedrock Proposition: Do not tax imputed income from home ownership (benefit of not having to pay rent) (Independent Life Insurance Case)

● Advantages of Home Ownership ○ § 163: Mortgage interest is deductible

■ 163(h): Only can be taken on primary and one other residence AND there is a $1 million mortgage limit

○ § 164: Real Estate taxes are deductible○ § 121: Can exclude $250k from income (500k if married) if selling home for a profit

■ Must be your primary residence

○ Ex: Why Renting Sucks: Two guys both make 80k a year. One has 100k in the bank and collects 10k a year interest and uses it to rent (taxed on $80k/yr + $10k interest = 90k). The other guy used the 100k to buy a home. (only taxed on $80k/yr NO interest).

○ Horizontal Inequity : If one wants to own and one wants to rent its unfair to tax them differently.

○ Vertical Inequity: The more expensive the home, the advantage to the homeowner increases and the disadvantage to the renter increases.

○ Distortion: The tax law is sending out a message: DON’T RENT, OWN !■ Ownership is good. Valuable to the economy and improves neighborhoods.

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● Owning a Car ○ Indep. Life Ins. applies to ownership of all assets. No imputed income from

ownership.○ Might be better to buy the car than using interest from money in the bank because

the interest will be income.

● Dean v. Comm’r: Case where guy owned stock in a corporation which owned a home that he lived in.

○ Corporations are separate from their shareholders○ The taxpayer has income (not an imputed benefit like in Indep. Life Ins.)○ Substance over Form is a One Way Doctrine:

■ It can only be invoked by the IRS, not the taxpayer.■ If the taxpayer chooses a bad form, tough life bro.

Final Gross Income Hypo:

Vegy grows vegetables in her garden:

● Gross income?○ No, not yet. This is self created property. (not taxed)

● What if she sells them?○ Yes, gross income. (taxed)

● What if she consumes them?○ Not gross income. This is imputed income from services. (not taxed)○ Administrative nightmare to tax imputed income.

● What if she traded her veggies for fish worth $100?○ Barter transaction, both have income. (Taxed)

Chapter 3

Gifts

Consumption Model:● Multi-layer taxation / repetitive taxation● Every time you pay for something, you don’t get a deduction and it’s income for someone

else also● “consuming” income doesn’t reduce taxable income● Spending for personal reasons is not deductible, business reasons is...

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§ 162 : Business Income Model● One level of taxation / Single taxation● Allows deduction of business expenses so its only taxed once (the person getting paid has

income)

● Business Expense Deduction: ○ Ordinary and necessary expenses paid or incurred in carrying on any trade or

business

§ 102 : Exclusions (Gifts)● Donee receive gift, and even though its economic benefit, it will be excluded from gross

income [not a deduction]● We only tax this once, to the donor (when it was donor’s income.)● Exclusion is similar to §121 (supra!) $250k excluded from home sale profit

Quick Note on Gift Tax: ● There is a separate tax in the code for people who make substantial amounts of gifts, so it is

taxed a second time but it is taxed to the donor again. This is gift tax, not income tax.○ Gift tax looks at the gifts you made over your lifetime (not just a single gift) to

determine enhanced capacity to contribute to the government.○ Triggers when cumulative gifts exceed $5 million.

Comm’r v. Duberstein:● Just because it’s a gift under common law doesn’t mean its a gift for purposes of § 102.

○ Common Law Gift: (1) Donor must have donative intent; (2) delivery; (3) acceptance● Depends on the substance of the transaction. If it was compensatory in nature, then it is

NOT a gift.

● Determining a Gift under § 102 ○ Look at the predominant motivation of the transferor (Question of fact)○ If it was love, affection, sympathy, “detached and disinterested generosity,” or a

similar charitable motive, then it is a gift.○ If it was more of a business motive, or designed to compensate someone, then it is

not a gift.

○ It’s a Murky Test: The transferee has to ask himself at the end of the year, what the predominant motive was of the transferor. Transferee wants it to be a gift so it doesn’t count as income. So if colorably looks like a gift, he probably will treat it as one.

■ Donor Intent = Factual Question for the Jury■ The court’s decision will be reviewed deferentially, not de novo, so they have

to affirm this fact finding issue; requires the finding to be “clearly erroneous” to overturn.

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■ This murkiness is bad for the self reporting system because it gives incentive for people to not to the right thing.

○ Additional factors for the Jury to determine Donor Intent: ■ The Nature of the parties relationship (relationship based on love,

friendship, business?)■ Whether the transferor took a business deduction

● Court said it would not make a per se rule about taking a business deduction, but will let it go to jury.

§ 274 Disallowance● To be entitled to a deduction, must be able to show a section which authorizes the

deduction● Disallowance Rule : If the item is a gift to the donee under § 102, then the donor CANNOT

take a business deduction.

§ 274 (b): De Minimus Exception:● Although transferee is not reporting it as income by calling it a gift, transferor can take a $25

deduction for each “small business-like gift” instead of the entire cost as a business deduction.

○ Once you get through § 162 Business Deduction [Business Expenses on one side (employer) - Gift on the other side (employee)] → $25 Cap for employer deduction

● Violation of business income model ○ Ex. Oil company sends calendars to #5000 clients.○ We allow them to deduct $25/per because it’s business motivated and not really

compensatory in nature

● BUT, General Rule: If its a gift in the hands of the payee, the payor cannot take a deduction.

Gans Idea: Rules are not very effective because the donee and donor are each making their own judgment call about whether its a gift or not. IDEA: make donor send notice to the donee that they are taking a deduction (“it was not a gift” - uncomfortable position)

§ 102(c) ● If an employer gives an employee something, it is automatically not a gift.

○ No need to worry about 274 disallowance rule○ 1986 Amendment to IRC adds a per se rule!

● Goodwin 8th Cir; Rev. Rul 55-422 : gifts made by congregants to the minister are not subject to § 102(c) because the congregants are not technically employers

○ May not deduct contributions to a person; charitable deductions are permitted when given to an organization

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AnalysisHypo: Clients invited his lawyer to his daughters wedding. Lawyer gave a generous gift (more generous than normal because of business relationship); does the couple have income? Can the lawyer deduct it?

1 Always start with Transferee perspective (Daughter):a Definately Economic Benefit. Is there a reason to exclude it?b 102(c): They are not employees of the lawyer. So it still may be a gift.c Duberstein: look at the predominant motive of the transferor.

2 Transferor’s Perspective (Lawyer):a Options: (1) Deduct $0 [b/c gift]; (2) Deduct Entire “gift” [b/c business deduction];

(3) Deduct $25 [b/c de minimis]b 274: Did the transferee have a gift under 102? If they did, the lawyer may not

deduct all of it as a business expense.i Still can deduct $25 (274 (b): de minimus exception)

c Duberstein : Makes the judgment based on his own predominant motive. i Note: If would normally give $250 but gives $1,000 because of business

relationship. can he deduct the extra $750?ii Murky because of self assessment. He will deduct the $750 but the couple

will likely treat the entire $1000 as a gift.

Dual Relationships● Employee is also the daughter to the employer● § 102(c): A “gift” to an employee is not a “gift” under § 102, and counts as income to the

employee● Duberstein: One of the factors to determine the predominant motivation of the donor is the

nature of the relationship● Familiar relationship and employer relationship !!!!

● Williams TC Memo 2003-97: case law indicates, § 102(c) should not apply if it can be shown that the gift was given NOT because of the employer/employee relationship, but because of the familial relationship or some other aspect, than can get out of § 102(c)

○ Gans: Don’t want to have to fire my daughter because I want to give her a gift to help her with a mortgage payment!

Ex. Mother-employer gives all employees a $120 case of wine at christmas. Son-employee gets a case of wine worth $700.

● Son-Employee-Donee Analysis : Gift?○ § 102(c): employer-employee per se rule excluded as gift○ HOWEVER, dual-relationship!! Basically two separate transactions going on:

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1 $120 of the $700 is income because of the son’s services as an employee -- every employee got that

2 Remaining $580 ($700-$120) could be argued as a gift■ It was the familial relationship (love, affection, etc.) which was the

predominant motivation for that portion● Mother-Employer-Donor Analysis : Business Deduction?

○ Two Transfers going on:1 $120 to every employee

a Business Deduction - Business Expense 2 Remaining $580 to son

a Predominant Motivation for the extra $580 was love, affection, etc - Gift○ $120 Deductible - $580 non-deductible○ NO $25 Dollar deduction for the $580 because it was determined to be a § 102 “gift” for

the son → once it is found a gift can’t now deduct by calling it a business expense

Inheritance● § 102: Inheritance / Bequests / Devises: EXCLUDED from gross income

○ Intestate: someone dies without a Will○ Bequest: giving personal property○ Devise: giving real property

● Nuisance Value : ○ Someone with no case (a nuisance) is contesting a will. The estate decides to settle

for $10k instead of paying $100k for Trial.○ Underlying claim nature is inheritance → Excluded as income, even nuisance value

settlement (too complicated to create a nuisance exception)

● Per Se Rule : If taxpayer was an intestate taker, any recovery he gets is inheritance

● Quantum Meruit claim: provided services and expectation of compensation○ Seen when two people live together and don’t get married and don’t have a Will.○ Living person will sue the estate and could allege a Quantum Meruit claim. However

any verdict/settlement for the underlying claim would be taxed because it was compensation for services provided (and not a gift as inheritance).

● Contract claim: promise to add someone to a Will and they fail to do so before dieing○ Underlying claim is relating to inheritance and any verdict/settlement will be seen

as a gift

● When both Contract claim and Quantum Meruit claim are alleged, and none have been dismissed, Contract claim is more important, and any verdict/settlement will be based on it for income determination

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Ex. Attorney renders services for chicks divorce in exchange for bequest of certain stock in Will when she dies. Income to Attorney? [Post-Duberstein]

● Predominant Motivation in giving attorney the stock?? [§ 102 - Duberstein]● Found: Compensation for services = Income, NOT gift

● SCPA 2307: Executor entitled to commission for services rendered as executor and it is a percentage of the estate

Merriam Case: In Will, “I bequeath the sum of $20,000 to my friend John in lieu of all compensation for the services he renders as my executor.”

○ Compensation and Income - or - Bequest and NOT income?○ Predominant Motive: Services○ Language: Bequest○ Treated as Bequest because of the language

● Potentially Narrow Proposition: Merriam Case (PRE-DUBERSTEIN but not overruled)○ Bequeath to this person a sum of money in lieu of compensation - might still be

excludable as bequest○ Not good language to use

Settlement Agreements● Settlement Agreement is taxed the same as you would a recovery on the underlying claim,

no different if a court verdict

● Tax consequences will depend on the nature of the claim asserted:○ Contested Will: §102 - Inheritance NOT taxed○ Tort and Damages: Personal Injury NOT taxed○ Contract Dispute over salary due: Taxed

● State Law Issues: State created labels / views of “income”○ IRS only interested in Substance of transaction ○ State law labels are not determinative

Hypos on P.66-68

Chapter 4

Adjusted Gross Income (AGI)

● Deduction versus Exclusion ○ Deduction is applied “above the line” or “below the line”

○ Taxpayer deducts certain money he paid…○ Exclusion reduces Gross Income right from the start

○ Taxpayer excludes certain money he received….

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● Two Categories of Deductions: ○ “Above the Line”:

■ § 62: Adjusted Gross Income: List of what deductions you can take Above the Line. (Gross Income) - (Some Deductions) = Adjusted Gross Income

● Includes: Business Expenses of a Non-Employee ● Ex: Sole Practitioner / anyone without a “boss”

○ “Below the Line”:

■ § 63: Taxable Income: (Adjusted Gross Income) - (Some Deduction) = Taxable Income

■ Taxable Income used on Rate Charts to determine tax $ owed

■ Generally: Mortgage Interest deduction on home (§ 163); State and Local Real Estate Taxes on home (§ 164); Charitable Deductions (§ 170); Medical Expenses, Casualties (fire, theft)

■ Business expenses of an employee

■ Below the Line: Can Take either:

● Standard Deduction : Automatic, dont have to show paid x for this, IRS just gives it to you

○ (2013, joint return was $12,200)○ Takes low income taxpayers out of the system (people who

can’t afford to contribute to the cost of gov.)○ Eliminated the need for bookkeeping which is needed for

itemized deduction

● Itemized Deductions ○ If your expenses are above the standard deduction amount,

prefer itemized○ Required to prove you are above the standard deduction

amount and list each expense○ [Income Tax return 1040 Schedule: lists itemized

deductions]

Analysis:1 Calculate Gross Income (accounting for any proper Exclusions)2 Subtract § 62 and other appropriate Deductions3 Calculate Adjusted Gross Income4 Decide if you want Standard Deduction or Itemized Deduction5 Calculate Taxable Income

(Example on Next PAGE)

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Ex. Sole Practitioner makes $100k, pays secretary $50k. Taxable Income for Lawyer? [Assume SD = $11,600]a Gross Income $100kb Any Deductions?

i § 162 Business Deduction permittedii Applied Above the Line or Below the Line?

1 § 62: non-employee expenses (sole practitioner = has no boss; if he was an associate it would be “employee” expense and below the line)

iii Salary of secretary is applied Above the linec Adjusted Gross Income = $50k ($100k - $50k)d Below the line deductions?

i No other deductions in hypoii Choose to take Standard Deduction $11,600

e Taxable Income = $38,400 ($50k - $11,600)

Medical Expenses

● § 213: The first 7.5% of your Adjusted Gross Income is essentially a “haircut” on your medical deduction

○ Ex. $100k AGI; Medical Expenses $10k. 7.5% of $100k = $7,500. First $7,500 is income, anything remaining is deductible = $2,500.

● Reason for Haircut: Involuntary medical expenses affect the ability for the taxpayer to contribute to the cost of government

○ A lot of medical expenses viewed merely as consumption○ Used for unfortunate, serious and extraordinary medical expenses

● Medical Expense Deduction applied Below the Line

Business Expenses of an Employee

● Below the line deduction is not necessarily going to pan out into tax savings. May not have value if you choose to take the standard deduction.

Ex. Law School says they won’t pay for JIBL or AZTECH so Professor pays it himself for $1,000.a Deduction?

i § 162: Business Expenses b Above the Line or Below the Line? § 62

i Since Professor is an employee → goes Below the Lineii If he was non-employee → Above the Line

c Standard Deduction v. Itemized?i Applied Below the Line: Will use Standard Deduction! No tax savings.

d MORE likely to ask the Law School to pay him $99,000 and $1000 for the stupid shitty Journal!!!

i Journal $1000 could then be excluded from professors income as Working Condition Fringe (Infra) [Straight $1k off Gross Income]

● Employee v. Non-Employee Expense ○ If you are an employee and your employer hasn’t provided something for you and

you buy it on your own, the code is suspicious/skeptical, if your employer didn’t give it to you you might not absolutely need it for the job.

○ If employer provides it, not skeptical, and you are NOT taxed on it

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● Non- Employee expenses goes Above the Line

● Employee Expense goes Below the Line, and must be itemized if you want to claim a deduction greater than the Standard Deduction

● § 67 [Code Amended]: Employee Business Expenses: ○ Categorized as Miscellaneous Itemized Deduction, so only get the benefit if you

itemize deduction○ 2% of Adjusted Gross Income “haircut” on total Miscellaneous Itemized Deduction

Ex. Professor again; AGI $100,000; All of the employee’s business expenses: $1,000 JIBL & $500 ACTEH, $500 Conference = $2,000.

a AGI: $100,000b Deduction? § 162 Business Expensesc Above or Below the Line? § 62 Employee Expenses → Below the Lined § 67 Employee Business Expenses: Miscellaneous Itemized Deduction

i 2% of $100,000 = $2,000ii Can take deduction on anything over $2,000iii Professors total expenses were only $2,000

e NO deductions!!! Only paid $2,000 and no Expenses over that to get deduction!f Paying tax on $100k AGI and also had to pay $2,000 for expenses!g Like Above: Better to work with law school to get less salary and have them pay for expenses

so they are fall into Work Condition Fringe, and get excluded from Professor’s Gross Income

Fringe Benefits

Fringe Benefits: ● Something you get from employment relationship over and above salary

○ Ex: Frequent flyer miles ● Not a gift because of 102(c) [employer to employee] but can still exclude from employee’s

GI

● § 132: Certain Fringe Benefits ○ If you get a fringe benefit of the type described in this section from your employer,

you may exclude its value from your gross income.○ 132(a) Categories

■ Working Condition Fringe Benefit■ No Additional Cost Fringe Benefit■ Qualifying Nature Discount■ De minimus Fringe■ Qualified Transportation Fringe

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● § 132 (a)(3): Working Condition Fringe ○ Anything provided to an employee by an employer if the employee would have been

entitled to a 162 business deduction had the employee paid for it himself.■ (Ordinary and necessary expense to carry on business)

○ Ex. Plumber gets a new set of tools from his employer■ It’s difficult to determine economic benefit because he may not want the

tools but needs them to do his job better. (Very Subjective)

○ Exclusions enjoyed disproportionately by high level employee■ Ex: CEO in a big nice office, flys around for business in a private jet. Great

benefit, but still working condition fringe because he would be able to exclude it as a business deduction had he paid for it himself.

● §132 (a) (1): No Additional Cost Fringe Benefit ○ Situation where there is no additional cost to the employer for providing the benefit.

■ Ex: Airline allows flight attendant to fly for free when there is a vacant seat. (No Cost to the airline). Attendant can exclude this from gross income.

■ “Excess Capacity Fringe”■ If they had to bump a passenger, no exclusion under 132.

○ Spouse, kids, etc. OK so long as no additional cost (bumping passenger/canceling someone elses hotel room = lost $$ = cost!)

○ This exclusion is not available to high level employees, UNLESS it is available throughout the company on a non-discriminatory basis.

■ Ex: Pilots fly free if there is a vacant seat but flight attendants have to pay 50% of cost. The policy is OK but the pilots won’t have an exclusion under 132.

○ Anti-Conglomerate Rule : Only get exclusion for the no additional cost service fringe or qualified employee discount if item you are purchasing is in the same line of business that you sell for the company

● Qualifying Employee Discount Fringe ○ Allows employees to exclude discount benefits from their income○ Must be non-discriminatory between high and low end workers○ See Anti-Conglomerate Rule: [Above]○ Exception to compensatory bargain purchase

■ Ex: Store sells item for $100 but allows employees to purchase for $75. Employee had $25 of economic benefit but it is excludable as a qualifying employee discount fringe.

○ § 132(c)(4) : NOT available with respect to real estate (real property) and not available for personal property of a kind held for investment.

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○ If employer sells to the employee such that the price is less than their cost → INCOME to employee is difference between employee price and employer’s cost

■ Look at profit markup for the entire year.■ Ex: Company bought $1 million in goods and had $2 million in profit. 50%

profit and 50% cost, so they can give their employees a 50% discount without them having any income.

● Company has 50% cost. Item normally sold for $100 but they sell to employee with a 70% discount. Employee has $70 economic benefit but only $20 will be income. [employee paid = $30; employer cost $50]

■ Service Company Discount: ● Employee can exclude up to 20% discount from their service

company. (First 20% tax free)○ Ex: $100 Service gives employee 30% discount. Employee

has $10 of income.

● De Minimus Fringe ○ Things that are low in value and not worth keeping track of. ○ Requirements: Low value, traditional, holiday/birthday, and NOT cash

■ Ex: Employer provides coffee. Employer is going to deduct this and the employees are going to exclude it as a de minimus fringe. We tolerate this violation of the business income model.

○ Often used to deal with odd-ball situations.■ Ex: Employee using work cell phone for personal (1-800-sexline) calls. [IRS

Notice 2011-72]

■ Ex: Allows occasional overtime meals to be excluded, when provided because employee is working overtime.

○ NOTE : § 102(c) prevents employer-employee gift exclusion → Since outside of § 102 NO $25 minimum employer deduction under § 274, and employer can deduct TOTAL cost as business deduction→ For employee: if it fits into the De Minimus Fringe requirements employee can exclude.

● Qualified Transportation Fringe ○ Rev. Rul 99-7: Cost of commuting to and from work is NOT deducible.

■ It was your decision to live far from your workplace bro.■ If employer reimburses you for commuting, that is income.

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○ Driving for a business need is “qualified” (not commuting).■ Ex: Lawyer drives to work, not excludable. But when he has to drive to the

court for a client and then back to work, that is driving for a business need and is a qualified transportation fringe.

■ When firm reimbursed the lawyer, it is excludable.

○ When employer pays for parking■ Can exclude up to a certain maximum the value of parking under this fringe

($240 per month), the rest counts as income to the employee.■ Some people don’t like this because it discourages mass transit. So...

○ Amended to include value of transit passes■ So if employer pays for your transit pass, you can exclude it [up to $125 per

month]■ CANNOT give you cash, must actually give you the transit pass

○ NO non-discrimination requirement between high and low employees

§ 119: Meals and Lodging Provided by an Employer● Not all fringe benefits are under 132● Requires non Discrimination between high and low employees

● Lodging Requirements: (1) the convenience of the employer; (2) required to use it as condition of employment; (3) it must be on the business premises of the employer

○ Employer can only give the employee the right to use the property, NOT title

● Meal Requirements: (1) convenience of the employer; (2) business premises requirement○ Gans doesn’t think there’s really a difference.○ Ex: Maid/Butler/Chef who lives on the premises and gets free lodging and meals.○ Note: Just because the employment contract has a clause saying that lodging is a

condition of employment doesn’t mean it qualifies under 119. Provisions will not be determinative (substance over form)

○ Dobbe: TC Memo 2000-330: Groceries do not qualify for excluded meals under 119. If employee gets whatever groceries he wants, that is income. No coercive effect from employer since employee is making the decision. If employer buys the groceries and employee has no choice, then probably 119 exclusion.

Hypos on P.80-82

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● Herbert Hatt Case: Dude had a funeral home, he lived there and worked there. He incorporated it and claimed lodging and meal exclusions under 119. It was allowed, although it violates substance over form because if he didn’t incorporate he wouldn’t have been an “employee” and would not qualify for 119. (form over substance!?)

○ Tax laws buy into the corporate fiction that a corporation is a separate and distinct entity. The IRC will respect the fact that if you work for your own corporation you’re an “employee”.

○ Hatt could now pay the residence portion of utility bills and for his personal meals with the corporation. The corp would take a business expense deduction and he would exclude his personal benefit from his gross income. This is a violation of the business income model.

● Comm’r v. Kowalski: State troopers were provided a cash reimbursement for their meals. They tried to get this excluded under 119.

○ Supreme court held that there is a difference between the use of the word “meals” and “cash reimbursement” and construes the term meals narrowly.

○ “meal”: meal provided in kind, not a cash reimbursement for a meal○ Rule: 119 does not apply when employer provides reimbursement for meals you

had over time.

§ 66-94: Imposes civil penalties on preparer of return (advisor) for taking a position without sufficient foundation.

Circular 230 (10-34): same as 66-94, civil penalties and violations, can result in disbarment.

Chapter 5

Prizes and Awards

§ 74 Prizes and Awards:● Prizes and Awards constitute gross income. (Economic Benefit)● Prior to § 74 taxpayers have argued it was a gift under § 102 and therefore excludable from

gross income.○ Ex: Prize on a game show, the predominant motivation is business reasons,

therefore seems like a gift under 102. However, now 74 is a per se rule that does not allow the gift argument for prizes and awards.

● What if you want to give award to a charity?

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○ § 170: Charitable Contribution Deduction: A “below the line” deduction with a limit on how much you can deduct. A person cannot deduct more than 50% of their AGI under this provision in any given year, the excess is carried over to the following year for up to 5 years.

○ Hypo/Problem : AGI is $50,000; award is $100,000; so now AGI is $150,000. This person is only allowed to deduct $75,000 (50% of AGI) as a charitable contribution even though they want to donate the entire $100k award to charity.

○ Rule: Code says that the 50% rule from § 170 does NOT apply if giving an award directly to charity. (Avoids the above problem)

■ Must go directly from organization giving the prize to the charity, cannot accept the award then give it to charity yourself.

● Remember: Only the government can make a substance over form argument. Taxpayer must be careful here.

● Employer “awards” employee with a business trip ○ § 132 Working condition fringe OR § 74 Prize ?○ It doesn’t matter how the employee got selected, it is still a working condition fringe

even though it feels like an award.

○ 274(m)(3) : Employer cannot take a business deduction for the cost of sending his employee’s wife on the business trip with him.

Education

● Generally: Education is treated as Consumption - NOT deductible as a biz expense● Argument for tax relief: Huge school bills affect ability to contribute to the cost of

government● However, not much sympathy for professional school bills (will have lucrative career)

Scholarships

● § 117 : A student who is a degree candidate can exclude a Scholarships from income (per se exclusion)

○ 1986 Amendment : Removed the Room and Board exclusion ONLY exclusion for Tuition (1986 - “widening the base” to lower taxes and removed some exclusions)

○ § 117(c) : If you are getting a scholarship in exchange for past, present, or future services rendered → that portion is NOT excludable and constitutes income

● Ex: School gives $10,000 of scholarship, but $5,000 is room and board and $5,000 is for tuition.

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○ Only the tuition portion is excludable.

● Ex: School gives $10,000 of scholarship but requires $1,000 of services (work in library)○ The services portion is not excludable under § 117. ($9,000 excludable)

● §117 Scholarship trumps §74 Award : Winning an education stipend○ Outside of employer-employee situation, no compensatory nature, not working for

people granting the stipend■ Employer-Employee Situation: Had § 117 (Scholarship), §127 (employer

provided education), Working Condition Fringe■ Outside Employer-Employee Situation: § 117 and §74 (Prize and Awards)

○ General Rule: Prizes and Awards are Income○ § 74: “except as otherwise provided in section 117, prizes and awards are gross

income”○ § 117 Controls!!

■ Substance: stipend is a scholarship, the fact that you “win” it as a prize is not substantial enough to remove it from the § 117 exclusion.

■ Similar to “winning” a business trip when the selection process is done via raffle. Substance is a working condition fringe, even though you “won” it.

Athletic Scholarships

● Rev. Rul 77-263: Athletic Scholarships are NOT income and are excludable● Seems like compensation for services, but not income

● STILL excludable if: ○ Contingent on GPA○ Student doesn’t play for a particular year and he is still given the scholarship for that

year○ Student gets a free ride for the first year but doesn’t play and the scholarship is

taken away after the 1st year

● Problem which will create INCOME: ○ School tells the the student the scholarship will be taken away if he misses one game

or taken away within the 1st year

Scholarship provided by the School to the children of School’s Employees● Gan’s daughter gets free tuition because Gans is a professor

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● § 117(d) : These kinds of free tuition for employees are not taxable and are excluded from income

○ Same principal as the free airline seat provided to employees - excess capacity○ MUST be nondiscriminatory to be excludable

■ Includes Professors, Secretaries, Janitors (Joe Dirt), everyone!

● Reciprocal Plan : Employers can set up reciprocal plans with other employers, so that the employee of 1 school can send his daughter to a reciprocating school for free and still exclude the cost of the tuition.

Cost of Education as a Business Expenses● NO deduction if the education you are pursuing is the minimum amount required to get into

that business● Education must be for the purposes of “carrying on” a trade or business [§162 Business

Expenses] [Regulation 162-5]● If the education paid for by student/taxpayer qualifies as a Business Expenses for them,

student/employee could get Working Condition Fringe if the employer payed for it.○ Can’t be general “college education”○ Must be specific enough to “hone your particular business skills”

Examples:● Law Student cannot deduct the cost of education as a business expenses

○ NOT yet “carrying on” a trade or business required under 162: business deduction

● Solo practitioner paying for a $2,000 course in tax law = Deductible business expense.○ “Carrying on” his business and incurred the expenses to hone his skill○ Deductible Above the Line because he is a non-employee.

● Gan’s paying for a $2,000 course in tax law and Employed of Hofstra. Deductible business expenses for Gans.

○ “Carrying on” his business and Gans incurred the expenses to hone his skills.○ Deductible Below the Line because Gans is an employee

■ Requires itemized deduction■ Subject to 2% haircut rule

● Hofstra pays for a $2,000 course in tax law for Gans. Deductible business expenses for Hofstra, Working Condition Fringe for Gans. (Money disappears from tax system)

○ Hofstra: gets a business deduction because they are “carrying on” their business by honing their professor’s skills.

○ Gans: gets to exclude this as a working condition fringe because he would have been able to take a business deduction had he paid for the class himself.

● Bar Prep Cost:

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○ Law School Graduate has now acquired new business by graduating ○ However, you still have not passed the acquisition phase to “carry on” business as a

lawyer [need to pass the bar with license!]○ NOT deductible

● LLM course after graduation?○ Still not “carrying on” if you go right into an LLM course after graduation○ “Carrying on” if you graduate, pass the bar, and work for employer to “hone skills”

■ Would satisfy § 162 Business Deduction■ IF EMPLOYER PAID:

● Employee could take Working Condition Fringe

● Employer pays for bar prep course to all new associates (nondiscriminatory). ○ Employee: CANNOT qualify for §117 Scholarship - Required to be in pursuit of a

degree - License is NOT the same as a degree (ALSO if required to work would be seen as compensatory and not scholarship)

○ Employee: NO working condition fringe - Employee could not get § 162 Business Deduction if they had paid it himself

○ § 127: Can exclude $5250 [INFRA]

§ 127: Employer Paying for Education● If your employer pays for your tuition, on a non-discriminatory basis with a written plan,

then you can exclude up to $5,250 of this from your income per year.○ Ex: Employer gives $10k for tuition, written and nondiscriminatory. You can

exclude the first $5,250 and the rest ($4,750) is taxable income.

Chapter 6Gains from Dealing in Property

Basis§ 61(a)(3): Gross Income includes “Gains derived from dealings in property”

● § 1011: How to Determine Basis (Return of Capital)○ Basis Principal Function : permit taxpayer to recover a return of capital, tax free: if

simply getting back your cost, no economic benefit and no gross income

● § 1012 : Deals with Purchases; Basis = CostRealized Gain/Loss

● § 1001: How to compute gain/loss ● Amount Realized (AR) - Basis = Realized Gain (RG)

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○ Amount Realized = Essentially the sale price■ The sum of money received plus fair market value of property other than

money received on the disposition.

○ Realized Gain = Recognized Gains■ Except as otherwise provided, all realized gains are to be recognized■ Ex. Gift Exclusion, Fringe Benefit

● Loss: ○ When § 1001 computation shows a loss, you don’t automatically get a deduction. §

1001 only gives a computation and doesn’t authorize a deduction.

○ § 165 Deduction on Loss: ■ Must be: (1) loss incurred in trade or business; (2) loss incurred in a

transaction entered into for profit; or (3) casualty loss.■ Code doesn’t want to permit deductions for consumption

● Ex: Bought suit for $1000, sell for $100. Basis is $1000 and Amount Realized is $100 (Loss of $900). Suit is not trade or business. We don’t allow a deduction because this was consumption.

● Ex 2: Same as above but stock in a company rather than a suit. This is now an investment and we would allow deduction of the loss under § 165.

● Note on Casualty Loss: Can only deduct the casualty to the extent it exceeds 10% of AGI

○ Ex: AGI is $ 100,000. Your $40,000 car fuckin’ explodes. You can only take a loss of $30,000. (10% of AGI is $10k, $40k -$10k = $30k)

○ The code relates the loss to your income to assess your ability to contribute to the cost of government.

● No Deduction for Loss on Home ○ Cannot take deduction for loss on the sale of a home under §

165. Although it is arguably a transaction “for profit” the code doesn’t buy it.

○ Exception: If it’s a home that you purchased to rent out for profit. (More like an investment). Conversely, now the § 121 deduction is not available (supra/ $250k exclusion)

Concept of Deferral

● Not taxed right away, carries over until you sell.

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○ Ex: A Bargain purchase is taxed when you sell it. (Deferred)

● Taxpayers love deferral because it has economic value by giving the taxpayer the opportunity to earn money/interest on money that would have gone to the IRS.

Taxable Exchange

● Giving up one asset for another. Taxpayer wants to enjoy the continuation of the deferral. The code doesn’t allow this and it is taxable on the spot.

● Generally exchanges are taxable. (The realized gain will be recognized.) (Barter)

● Ex: Trade $500,000 worth of stock for $500,000 shopping center. (Bought stock a long time ago for $1000 so basis is $1000). The taxpayer was enjoying the deferral on the stock all these years, and wants to continue to defer the tax until he sells the shopping center. The code says no! This is a taxable exchange and his realized gain ($499,000/ value of shopping center) will be recognized (taxable).

How to Deal with Basis:

1 Function 1 of Basis : return of capital investment2 Function 2 of Basis : If you receive some kind of non-cash asset, and you recognize a gain on

that asset, then you can increase your basis equal to that recognized gain [“Function 2 Basis Step-up”]

a Receiving cash → No Basis concept for your cash [just income]i Foreign Currency might have basis

b The “Step Up”: Add back in the amount of recognized gain

● When you do a taxable exchange [i.e. you can calculate realized gain and therefore pay tax on that amount] your basis in the newly acquired asset is equal to the fair market value

Peel Rule: ● Calculating your Basis in the received asset when you do an exchange and have a Deferral →

No Recognized Gains (Ex. Don’t know value of either asset - Philly #3; § 1031 Exchange - INFRA!!)

○ When you acquire land for $100, let’s say you put a note on it indicating the basis of §100

○ When you do Philly Rule #3 Deferral you “peel” the “note” off the asset you originally had and attach it to the new asset which you received [Same applied for §1031 Exchange]

Philadelphia :

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● Exchanges are generally taxable, but on occasion there might be a nontaxable exchange● § 1012: when you purchase an asset its basis is equal to cost● § 1001(c): all realized gain is to be recognized gain except as otherwise provided

○ Recognized Gain: realized gain which gets added to gross income; some code sections provide exceptions which will prevent realized gain from being recognized gain

● When you qualify for a § 121 exclusion - it is permanent - NOT a deferral

Rules for Taxing Exchanges [Determining Amount Realized & Basis]

3 Rules of Philadelphia:

1 [KNOW VALUE OF BOTH] Basis in newly acquired asset is equal to the fair market value of asset received

a Don’t want to double tax on same gainb Accounted for any gain recognized already stemming from the transaction and paid

tax on that, so now your basis in the new asset accounts for that c Function 1 and Function 2

2 [DON’T KNOW VALUE OF ASSET BEING RECEIVED] If you don’t know the value of the asset received, the value of asset received is equal to the fair market value of the asset given

a Need to think about the amount realized of received asset; if receiving a painting and don’t know value, infer the value is equal to the value of real estate which is being given

b Use this “assumed” amount realized to calculate your realized gain from the transaction

3 [DON’T KNOW VALUE OF EITHER ASSETS] If you cannot determine the value of either asset, cannot determine amount realized, will not tax the exchange!! Allow you to defer the gain!!! [PEEL Rule Applied]

a Taxed when you sell the asset you received -- accounted for when you can determine an amount realized from a sale to someone else [occurring after the original exchange]

§ 1031: Exchange of Property for Investment● If you do a like-kind exchange, meaning the two assets (one given and one received) are of a

similar quality, and the assets are being used in trade or business or as an investment, then there is no recognition of gain on the exchange - TAX FREE [PEEL Rule Applies to determine your basis in the new asset]

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○ ONLY asset used in trade, business, investment○ NO securities exchanges (stocks)

● With Real Estate: requires a Qualified Intermediary if the owner of the property you want doesn’t want to exchange for your property but wants cash!!

○ For a fee: a third party buys the property you want from the original owner who wants cash not trade, and then exchanges with you under § 1031, than third party sells your original party

Example 1:● Farmer 1 wants to exchange land with his neighbor, Farmer 2; Exchange Taxable?

○ Farmer 1 paid $100 for his land = Basis in his original land○ Farmer 2’s land value being exchanged = $500 = Amount Realized○ Amount Realized - Farmer 1 Basis = Farmer 1’s Realized Gain

■ $500 - $100 = $400 Realized Gain to Farmer 1○ 1001(c): All Realized Gain = Recognized Gain unless exception applies

■ NO Philly Exception: Know Value of Each Asset■ § 1031: LIKE-KIND exchange !!!

○ § 1031 permits tax to be deferred● Farmer 1’s Basis in his new asset??

○ PEEL Rule: Because of §1031 Deferral, No Recognized Gain during Exchange■ “Peel” his $100 Basis and put it into New Asset

Example 2: Real Estate Investment● Own a shopping center in NY and want to buy one in FL

○ NY shopping center cost $100k = Basis in NY shopping center○ FMV = $1,000,000

■ If straight up sale: $900k Realized Gain○ Find Florida shopping center with FMV = $1,000,000○ Setup 1031 exchange!

■ Like Kind exchange of asset used for investment■ No Recognized Gains = Tax Deferred

○ “Peel Rule”: Carry over $100k basis from original NY shopping center to florida shopping center

● GET OUT OF REAL ESTATE AND STILL USE 1031 ○ You want to get out of real estate investment, but don’t want to pay the tax if you

straight up sell the property○ Long term lease with someone (ex. CVS) and they pay your monthly rent in cash,

instead of interest you would have gained by investing the straight cash.○ You can do a § 1031 exchange to get a piece of property that CVS wants to escape

paying tax while also getting rent payments!■ NOTE: still paying tax on the income from rent payments!

○ In reality: you have a piece of paper - promise from CVS to pay rent - not property

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● Borrowing Money to purchase :○ Crane Case: if you agreed to pay back a loan then we are going to assume i will pay it

back: if i take on debt to buy an asset, it is viewed as my money○ Ex. Purchase for $10,000. Borrow $2,000 and pay $8,000 cash. Basis?

■ Basis: $10,000.

Boot● Exchanging property and one person is getting extra cash on the side because the fair

market values are different [real world situations]● Receiving cash does not qualify as a like kind property under § 1031● Separate and tax the cash portion while the land exchange gains a § 1031 deferral

● Dealing with boot - In non-recognition model:○ The amount of gain recognized is equal to the lesser of: (1) the realized gain;

OR (2) the amount of boot received

Analysis: GAINS AND BASIS ARE TWO SEPARATE ANAL-SEEDS!!!1 Need to calculate the realized gain and recognized gain2 Need to calculate the new basis in the property you receive

Example: ● Josh wants to exchange NY property with Rob’s Florida Property:

○ Josh: FMV=$110; Basis=$105. ○ Rob: FMV=$105; Boot: $10.

● How much gain does Josh Recognize? What is Basis in new property?

(1) Recognized Gain: (2) Basis in New Property?

Amount Realized: $100 + $10 = $110Basis in NY property: - $105 Realized Gain: $5 [BOOT RULE]: ($5) v. ($10) = $5[Any Exclusions?]

Recognized Gain: $5

[Tax Paid on $5 Now - economic gain]

Function 1: [PEEL RULE] $105

Add (any new cash added) + $0Subtract (any cash taken) - $10 $95

Function 2: (Add Basis Increase)(Amount Realized): + $5

New Basis in FL Property: $100

MORE Basis Hypos p. 108-110

§ 1016: Adjustment to Basis● Basis is upwardly adjusted if you put more capital in

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○ Ex: Extension on House. $10,000 Basis in a house. You add $2,000 and build extension. New basis = $12,000.

○ (Also says depreciation lowers basis, infra)

Blatt Blatt Blatt! : Tenant build structure on your land. Income?● Case : Rented land on which tenants built movie theatre.● Held: Not Income. Defer in effect. Do not want to deter this. It will be taxed when sold. Basis

remains what it was.

● § 109: Even when the lease terminates, it’s still not income. Will be taxed when its sold.

● Supreme Court Intent Question: Was the improvement intended as additional rent or was it more in the nature of something the tenant wanted. (now adopted in reg. 61-8(c))

○ Don’t want to let Blatt rule exploit barter situations○ Ex: Build a movie theatre on my property, use it for 5 years and I won’t charge you

rent = INCOME! Taxed now, no deferral.

○ Note: Draft a good lease! Language should say any structures built are to facilitate tenant business and is not intended as rent.

■ Gans: Intent allows taxpayers to play with issue and avoid the income outcome.

IRS Estoppel Argument● Ex. Find a diamond in the street worth $10,000. Income! Economic Benefit, etc! Pay taxes on

it. Basis = 10,000 (Function 2 step up). BUT what if you never paid taxes when you found it?● IRS cannot audit the earlier return because there is no fraud so 3 yr SOL.● However, IRS can successfully argue estoppel from saying your basis is $10,000 since you

never paid tax on it.

● Ex. Basis of Compensatory Bargain Purchase Transaction:○ Paid $1,000 for Piano worth $100,000 from my employer in exchange for work.

■ Compensatory: PAY TAX NOW on Income - $ 99,000■ Basis in Piano = $100,000 [Already paid tax]

○ Once you say you show income - Function 2 Basis step-up: showing you how that income has to trigger step-up or you will be taxed twice on the same income

○ If you don't report the income (ex. finding a diamond ring on the street and not reporting it) you cannot get basis step-up when you go to sell it and price has gone up

Example of Basis Working with Other Rules: ● Buy a painting that retails for $10,000● Used employee discount and got it for $9,000● What is your basis?

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○ 132 Qualified employee discount: essentially can’t be an investment

● If Painting is an Investment: 132 doesn’t apply and need to recognize 1,000 of income.○ Function 1 = 9,000○ Function 2= 1,000○ Basis = 10,000

● If Painting is NOT an investment: 132 applies. No income.○ Function 1=9,000○ Function 2= 0○ Basis = 9,000

Basis in Gifts

§ 1015: Basis of Property Acquired by Gift

● (The Gift Model codified Taft v. Bowers)

● The gain that accrued on the donor’s watch shifts to the donee. ● The donee recognizes the gain when it’s sold. (Not when received! - §102)● Donee’s basis = Donor’s basis.

○ Basis remains permanently fixed to the asset when gifted. (“sticky note”).

● Hypo : Gans has an asset he bought for $ 1k (basis) and now its worth $ 2k. He shifts it to his daughter-- not income to daughter (§ 102). What happened to the $ 1,000 of gain? Does it disappear? Tax to Gans when he makes the gift (like a sale)? Tax to daughter when she sells?

○ § 1015: Donee basis = donor basis○ Tax to daughter when she sells. (Her basis = $ 1,000)

○ Reason: We don’t want to permit disappearing gain.

● We allow Gain shifting, but not income shifting. ○ Ex: Income Shifting. Assignment of Income Doctrine: Gans cannot assign his salary

to his daughter. He’s trying to game the tax system b/c daughter is in lower bracket.

○ We don’t care about Gain shifting because most gain that one has from selling an asset is “Capital Gain” which has a max tax rate of 20%. People cannot shift capital assets to lower their marginal bracket. (As seen with income shifting).

■ Gain Shifting when Sale is Imminent.

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● Ex. Instead of Gan’s selling his house and raising his marginal tax bracket, he decides to gift it to his daughter and have her sell it immediately. (Sale is imminent).

○ Substance over form○ Step Transaction Doctrine

■ IRS will probably prevail if the sale was fairly imminent.

■ removes the “daughter’s” step and treated as if Gan’s sold it directly

Transfers Between Spouses

Farrid and Davis Cases: p. 118 - 120

§ 1041: Transfers between spouses qualify for the gift model ● Husband and wife are treated as one economic unit● No gain recognition even if the wife gives the husband valuable consideration in exchange

for the transfer● NO recognition of gain to transferor and basis transferred:

○ Transferee steps into the shoes of transformer● Designed to overrule Farrid and Davis

○ Failed to overrule Farrid!! (Farrid-transfer made when they weren’t spouses or former spouses)

■ DIDN’T address the prenup situation (Farrid)○ Overruled Davis: fixed divorce situation

Hypo: What happens now in Farrid Situation?

● Transfer made before marriage → Might Have Gain!○ Advise Client: Wait until you are married for transfer to qualify for § 1041!!! ○ §1041: NO GAIN Recognition! Basis Transferred!

● Draft Anti-nuptial Agreement: “Give asset in exchange for release but my obligation to do so only becomes effective at consummation of the marriage”

○ Considered “married” so falls under § 1041!!● Even without the recommended language in anti-nuptial: Some states view the parties as

having intended to make the transfer when the marriage occurs

DOMA● For all federal purposes (including tax) same sex marriages are treated as not-marriages

○ § 1041 CANNOT APPLY○ Back in gain recognition situation

Examples

HYPO: § 1041 Today: Husband and Wife Getting Divorce

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Husband and Wife are getting a Divorce. Asset A: FMV $1,000,000 - Basis $0. Asset B: $1,000,000 - Basis: $1,000,000. Husband has title to both. Husband wants to give an asset to wife in exchange for a waiver of her rights.

● Representing Husband: Husband owns both assets and wants to make the transfer○ Husband gives Asset A (FMV: $1,000,000 with $0 basis) to his Wife○ § 1041 → NO gain recognized

● Representing Wife: Gets Asset A in exchange for waiver of rights○ Asset A carries over the Basis of $0 to the wife!○ When she sells, she will have huge gain ($1,000,000)○ She thought she was getting a 50-50 split of the assets and both were walking away with

$1,000,000! WHEN SHE SELLS SHE WILL GET BENT OVER!○ Whoever gets the asset with basis of $0 needs to get compensated for taken on that liability

■ For Divorce Lawyer: Two Columns for each asset - (1) FMV (2) Basis!! ● Two Consequences of Gift Model

1 Transferor recognized no gain

2 Basis is permanently attached to the assetAFTER HYPO: Cash Purchase Between Spouses

Wife: Asset with Basis of $1,000. Husband buys it from the wife for $7,000 in Cash.● Husbands Basis?

○ Under § 1041: Subject to Gift Model○ Wife’s basis is carried over with property = $1,000

● How Much Gain Does Wife Recognize?○ § 1041: NO GAIN recognized

ALL DAY: Taxable Exchange Between Spouses Two Assets both worth $1,000,000. Husbands Basis - $0. Wife’s Basis - $500,000. Agree to exchange.

● Husband’s Recognized Gain?○ Acquired an asset with $1,000,000 with a Basis of $500,00 in exchange for an asset with

$1,000,000 and a Basis of $0.○ Has Realized Gain → But does it become recognized gain?

■ Taxable or does any rule permit tax free exchange.■ Feels like spouse could apply (§ 1041) → NO gain recognition = gift model■ ordinarily this would be taxable exchange (1,000,000 - 0 = 1,000,000) but 1041

prevents it from becoming recognized gains● Husbands Basis in new asset?

○ §1041: Basis is attached to the asset when exchanged○ Husband got Wife’s asset which had a basis of $500,000.○ Husband’s Basis in the new asset = $500,000

● Wife’s Gain?○ Realized Gain ($1,000,000 - $500,000 = $500,000) but §1041 cuts it off○ NO Recognized Gain

● Wife’s Basis in asset received?○ 1041: basis is attached to the asset during exchange○ Wife gets basis of the asset which she received = $0 (The Basis which Husband’s asset had)

● Wife is pissed off: lost her $500,000 Basis and received an asset worth the same as what she gave up!!

Like-Kind Exchange Between Spouses (1031?... Nope! 1041)

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Real Estate for Real Estate (like-kind) both held for income productive purposes (investment / business) → § 1031 or § 1041?!!!

● Treas Reg 1041-1(T)(a)(2): § 1041 Controls!!○ Both § 1031 & § 1041: NO Gain recognition○ Basis Calculation would be different.

■ 1041: basis is attached to the property during exchange■ 1031: peel rule! each person peel’s their basis and attaches it to the new

assist they receive.● Prevent intact married couples from choosing § 1031 (so one person could can peel off a

high basis onto a previously low basis asset during an exchange) and then sell the asset using the basis to reduce recognized gain.

Hypos: p.125 - 126

Anti-Cherry Picking Rule

§ 1211: Limitation on Capital Losses (Anti-Cherry Picking Rule)

● All capital losses can only be deducted to the extent that you recognize capital gain that year. (Usually will be stocks).

● Capital Losses are deductible ABOVE THE LINE ○ Two Exceptions:

■ De-minimus Rule: Can deduct up to $3,000 even if no capital gains. (Can go against ordinary gains)

■ Can carry over loss into future years indefinitely: Until there is capital gain to deduct from, and deduction is “used up”.

○ § 1211 Defines the terms capital gains and capital loss

Analysis: Want to deduct a loss?● § 1001: Calculate Loss● § 165: Is it Deductible?● § 1211: Limiting Capital Gains Losses● Carry over any remaining Capital Losses

● Hypo: Capital loss of $100,000.

○ Capital Gain of $ 20,000. Now can deduct $20,000 of losses and carry over the $80,000 of loss until next year.

○ Next year there is $ 0 gain. Can deduct $3,000 (de-minimis) and carry over the $77,000 loss until the next year.

Exception to Gift Model: Losses

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● Gift Model (§ 1015): Basis = remains permanently attached to the asset.○ Anti-loss shifting is an exception to the Gift-Model.

Anti-Loss Shifting Rule: ● Losses accruing during the donor’s ownership of the asset cannot be shifted to the donee.

○ This Rule Deals ONLY WITH LOSSES. We allow gain shifting.

● 1st Question: Was there a Loss?? ○ Loss: Selling under FMV at the time of gift.○ Gain: selling over donor’s Basis○ Middle Ground: No Taxable Gain - No Deductible Loss = Selling between FMV and

donor’s basis.

● If there is a Loss ○ To Compute Loss, the Donee must use as basis, the lesser of the donor’s basis OR the

fair market value of the asset at the time of the gift.

● Ex: Donor’s basis in a gift is $ 100. FMV at the time of gift is $ 50.

○ Donee sells for $ 30 [Represents a “loss” when selling under the FMV when gifted] B/c there is a loss, can use different basis calculation.

■ Basis = lesser of donor’s basis or FMV at the time of gift [Basis = $ 50]■ Donee can report a $20 loss. (assuming § 165) ($30 - $50 = - $20)

○ Donee Sells for $ 100 ■ Basis = $ 100. No Gain, No Loss. Anything over $ 100 is taxable to donee.

○ Donee Sells for $ 80 ■ Cannot deduct loss because the loss was on the donor’s watch. Cannot tax

gain because the donee has not had any gain until sold for over $ 100.

● Anti-Loss shifting is a trap for the unwary○ people won't realize that the basis goes down after the exchange, and the donee

won't be able to use the loss○ Loss will disappear!! ○ Not a good idea to exchange an asset which declines in value! The decline won't

create a deduction!!

● Gift to a spouse with a loss? ○ Anti-Loss shifting rule DOES NOT APPLY to § 1041 transfers between spouses○ one economic unit!

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Part Sale - Part Gift[WON'T have Anti-Loss Shiting AND Part Sale-Part Gift → Didn’t do in class]

Ex: Gans owns an asset: Basis $10, FMV: $100. Gives to Daughter for $50. ● Income to Daughter? Daughter’s Basis in Asset?● Bargain Sale to Daughter = GIFT under § 102. [so no gain to daughter]

● IRS Reg:○ Gans Basis?

■ Realized Gain = $40■ Sold for $50 with Basis of $10.

○ Daughter Basis?■ Basis in Asset = $50

● Donee investment = $50● Gans original basis of $10 + $40 = $50 (also equal to what she

invested)

● Academic Literature Model NOT THE LAW○ Separate Transaction into components (apportion the gift and sale aspects) ○ Selling half and gifting half to Daughter

○ FMV = $100 & Price = $50 → price represents ½ of asset - Basis is split evenly■ 1/2 of the total $10 basis for each transaction = $5

○ Selling Half: Price = $50, Basis = $5○ Gifting Half: Basis $5 carried over because it is attached to asset

○ Donor Gains: ■ Sale: AR ($50) - Basis ($5) = Realized Gain ($45)

● DIFFERENCE FROM LAW: LAW puts full basis into sale aspect, and nothing apportioned into gift aspect

■ Gift: No Gains from a gift

○ Daughter’s Basis: donee basis + donee’s investment = $55■ Gift transaction: donee basis ($5)■ Sale transaction: donee’s investment ($50)

Testamentary Gift Basis

§ 1014 Basis Of Property Acquired from a Decedent

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● The basis of an asset acquired by testamentary gift is the fair market value of the asset at the Donor’s death.

○ This creates Horizontal inequity:■ Some people enjoy disappearing gain, and some people don’t. Depends on

the FMV and Donor’s Basis.

○ Also creates Vertical inequity■ Lower end people don’t have a lot of assets with great appreciation value.

Enjoyed more by upper end people.

● Death-Bed Gift Might be a Bad Idea ○ If you gift when still alive, basis will be calculated subject to 1015 (sticky note). If

just gift in a will, the basis may rise to the FMV and the donee can enjoy the disappearing gain.

○ Ex. Asset FMV = 100 and basis = 10.■ Gift Inter Vivos (1015): Donee’s basis = 10■ Testamentary Gift (1014): Donee’s basis = 100 [disappeared gain! yay]

● 1014(e) (Closes a loophole)

○ The Old Loophole: Gift asset to dying friend and have them give it back in their will. This can increase your basis to the FMV!

○ Rule: 1014(e): If the gift is made to the decedent within 1 year of death and then the asset is bequeathed back to you or your spouse, you do not yet the 1014 basis adjustment.

■ Note : Only to you or your spouse. The loophole doesn’t count your children or anyone else. However, service may argue step transaction doctrine and substance over form. Taxpayer then argues that death was not a pre-arranged “step”.

International Trading - Employer giving asset to Employee

International Trading

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● Rule: When an employer gives an asset to an employee, we use the Sale/Purchase model (1012) rather than the gift model (1015) for computing basis.

● Ex: Employer has an asset worth 100 with a basis of 10. Employer decides to give the asset to employee as a “gift”

○ First Tier of Analysis (Amount Realized)■ Employee will have income (102[c] not a gift). The income is equal to FMV

so income = 100.■ Employer can take a business deduction.

○ Second Tier of Analysis (Gain/Basis)■ Employer is treated as having made a sale (using sale-purchase model).■ Employer recognizes gain of 90. (basis 10, FMV was 100)■ Employer deduction = 100. (no sympathy for recognizing the gain)■ Employee’s basis will be 100 (already taxed on 100 so function 2 step up)

● Need to get appraisal to know the value of the deduction (which triggers the gain). Still no sympathy because the gain will never be higher than the deduction. (Gain will never be higher than the value of the asset by definition).

● International Trading DOES NOT APPLY IF talking about spouses. ○ 1041 will apply and husband/employer will have no gain.○ Reason: Mostly filing joint returns so it will wash out at the end of the day.

○ Ex: Husband is the employer and Wife is the Employee. Husband gives wife/employee an asset. 1041 applies, not International Trading.

■ Recap: 1041 = spousal transfers are treated as a gift (gift model 1015)

Depreciation Deductions

§ 167 and 168: Depreciation Deduction● In order to take a depreciation deduction, the asset must be used in trade or business, or to

produce income.○ Some things are never subject to depreciation deductions

■ Land is not subject to depreciation deduction. (Doesn’t get used up). However, the cost of improvements can (Ex. build factory on land).

● Straight Line Depreciation: It will decline equally in value each year.○ LOOK FOR ON TEST: Question will say what “LIFE” to use (X-number of years)

○ Ex: $5,000 machine with a “life” of 5 years. It produces 1,200 of income per year.■ In effect: Investing 5000 to make 6000. (1,200 x 5 years - 6k)

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■ Assume it will depreciate on a straight line basis (1k per year for 5 years)■ In year 1 : 1,200 of income, 1,000 depreciation deduction. (200 income).

● 200 per year for 5 years = 1000 (same in effect).

● § 168: The Code permits accelerated depreciation ○ Realistically the machine probably doesn’t depreciate 1k each year. Maybe 300 the

first year, 800 the second year, etc... The code is generous and allows accelerated depreciation deductions.

○ Taxpayers like the deductions soon rather that later--- save tax immediately.

§ 1016: Adjustment to Basis● Basis is reduced by the amount of depreciation deductions.● Required to have a Basis in an asset to get depreciation deduction on the asset!

Tufts and Crane● Question: People borrow money to buy Assets: what is the impact in terms of amount

realized and basis? [basis and basis reductions from taking depreciation deductions]● Regulation 1001-2: Codifies rules from Crane and Tufts.

Borrowing:● If I lend someone $100, that person doesn’t have income because there is no real economic

benefit.○ Have $100 cash but $100 liability to repay

● Buying an asset without the cash:○ Seller Financed : Buy an asset from seller and pay the seller an amount in

installments over a number of years○ Borrow Cash : Buy an asset from the seller and he gets a lump sum, I repay the

lender■ lender might want mortgage on the asset, so he can get the asset if you don’t

pay

Someone Buys Asset with Mortgage on it● Selling an asset with a mortgage on it - TRIGGERS DEBT - Buyer cannot take over mortgage● When someone takes over your mortgage:

○ You see Economic Benefit!!○ Buyer is taking over your liability!○ If your debt is assumed by purchaser, it enters into Amount Realized, as if you

received valuable consideration [Crane]○ Disposing Debt - included in Amount Realized

Getting Loan - What is Basis?

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● When you get a loan, treated as if you invested capital because of the likelihood of repayment - grants you a basis in the new assets!

○ Crane & Reg 1001-2: Treat Liability as if you were going to repay○ Debt incurred in acquiring Asset - included in basis

● Now that you have a “basis” you can take depreciation deductions against that basis!!

Ex. Buying an asset with borrowed money for $100. Note says you will promise to repay $100. Asset has 5 year life, and you want to take depreciation deduction in year 1.

● Even though you didn’t invest capital yet - treated as if you did because of promise to repay the $100 loan

○ Because of high likelihood of repayment - Can now include the loaned money into basis calculation

○ Basis = $100● Now that you have a Basis, can take depreciation deduction which in turn lowers that basis!● $100 FMV and 5 year life = $20 / year depreciation deduction over the 5 years● Basis will be reduced by $20 - giving you $20 depreciation deduction / yr

Example: Calculating Gain [Basis = loan b/c high likelihood of repayment]● Someone agrees to buy my building for $120. I got $100 note from bank when I bought it

originally. Building is encumbered by a mortgage!○ $120 (AR) - $100 (b) = $20 (Gain)○ Pay Back $100 to bank and see $20 Gain!○ Made $20 Gain without ever actually investing any money!! [Concept of Leverage]

● NOW: I took depreciation deduction in 1st year. SOLD building in 2nd year.○ B: $100 - $20 (depreciation deduction) = $80○ $120 (AR) - $80 (B) = $40 (Gain)

■ $20 of Gain is from sale■ $20 of Gain is from depreciation recapture (took false depreciation since

asset didn’t lose value - need to pay this back!)● NOW: Took depreciation still, SOLD for $80.

○ $80 (AR) - $80 (B) = $0 (Gain)○ Asset DID lose value - depreciation!○ I saw $20 loss of investment.

Recourse v. Non-Recourse Note● Recourse Debt : (Personal Liability) - If you don’t pay back the loan, lender can sue you

personally● Non-Recourse Debt : (Involves a mortgage) - If you don’t pay back the loan, only recourse is

against the asset, not against the person

Non-Recourse Note : ● 3 Ways Non-Recourse Debt can originate:

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1 Purchase asset and provide in note it will be without recourse against mea Bank will likely charge extra interest in exchange for the higher risk

2 Own an asset encumbered by a mortgage; Purchaser comes and agrees to take over the mortgage; and purchaser agrees to “assume the mortgage”.

a Assume : purchaser agrees to pay and will be personally liable for failure to payb Subject to the mortgage : purchaser taking on mortgage that is non-recourse,

purchaser is not personally liable to repayi So if don’t pay: purchaser will lose the property but the bank can still

come to original person, not the purchaser3 Original Person had Recourse Debt but died. Person who inherits an asset through a

will is not personally liable on the mortgage, the debt becomes non-recourse.

Crane

Basis for income tax purposes with Non-Recourse Debt : [Crane]● Non-Recourse Debt treated the same as Recourse Debt and included in basis!!

○ Assumed you will repay the mortgage - so treated as if you paid in “cash” from your pocket = capital investment

Ex. Calculating Basis on Inherited Asset with Mortgage. FMV = $10; Mortgage = $10K● § 1014: basis when you inherit an asset is the FMV● Property Subject to Mortgage = $10k● FMV = $10k with Mortgage = $10k → NO Equity

○ Assumed she will repay the mortgage○ Treat Recourse and Non-Recourse the same

● Basis = FMV!! [$10k]○ If basis started at $0, each repayment of mortgage would provide an upward basis

adjustment (investment of capital), creating a very messy situation

Abuse of Crane:● Negative Equity : Value of the asset is way less than the amount of the debt

● Can only include non-recourse debt into basis if there is a likelihood of repayment○ Likelihood of Repayment: Where the value of the asset is at least equal to the debt

[like Crane] or greater than the debt● If the value of the asset was less than the debt (negative equity), NO likelihood of

repayment, CANNOT include non-recourse debt into basis

Tufts

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Any Debt You get Rid of is Included In Amount Realized (even non-recourse debt) [Tufts]

● Ex: Taxpayer purchased property with non-recourse debt of 1,800,000.○ Basis = 1,800,000. Property value declines to 1,400,000.○ New basis = 1,400,000 (he took depreciation deductions)○ Taxpayer finds a buyer to take property “subject to the mortgage”

■ IRS says he had a gain of $400,000. (because his amount realized was 1,800,000 when the purchaser took over his mortgage and his basis was only 1,400,000)

■ Taxpayer tried to argue “negative equity” from Crane by saying that he had “no likelihood of repayment” so non-recourse debt is not included in basis.

■ Tufts Rule: Any debt you get rid of, even non-recourse, is included in amount realized. (IRS wins, he had a gain of 400,000).

● Don’t care about the Crane “likelihood of repayment test” at the time of the sale.○ Only at the time of purchase to determine basis (for false depreciation deductions).

Capital Gains

● Character of the gain is important: capital gain or ordinary gain?○ Capital Gain gets put into a separate “basket” for taxing

● Reasons for Capital Gains Lower Tax Rate:○ Compensate for IRS failure to adjust for inflation

■ Most of the gain over the long term of an investment is merely inflation which gets included in amount realized and taxed

○ Prevent “Lock-In”■ Taxpayer has the “trigger” in his hand (deciding when to sell) which will

cause the tax liability - resulting in taxation of the gains■ If you will get taxed at top marginal bracket (35%) might not sell the asset!!

● Capital Gain : Subject to maximum of 20% tax rate● “Long Term Capital Asset” : Capital Gain max of 20% rate of tax

○ Long Term : Longer than 1 year (1 year and a day)○ § 1221 Capital Asset : Negative Rule - (Broad Definition) Almost all assets are capital

assets, except for what is listed in the code

Ex. Own a home for 1 year and a day● Get $250k ($500 if married) exception on the income from sale● Anything over that exception taxed at 20%! Capital Gain

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Ex. Sell Stock - Basis: $10k; FMV: $20k● If you own it less than a year and a day = Ordinary Income Tax Rate

○ $20k - $10K = $10 K Income @ Marginal Tax Bracket Rate● If you sell it after a year and a day = Capital Gain and 20% tax rate

○ $20k - $10k = $10k @ Capital Gains 20% Tax Rate

Exceptions to Capital Gain:● Inventory : people who buy and sell inventory do not have capital gains

○ Ex. Department Stores, Electronic Stores, etc.○ Holding onto the inventory is not “long term investment”○ They bought the inventory for the purpose of selling it○ NO worry of “lock-in” preventing the sale of the items

■ Whole point is to sell your inventory○ Real Estate as inventory:

■ Taxpayer owns multiple lots and builds houses to sells in pieces, are the lots “inventory”????

● § 1245 and § 1250: Depreciation Recaptured ○ If you took depreciation deductions on a false premise (asset didn’t actually

depreciate and you sold it for a gain), the gain is “recaptured” as ordinary gain■ Depreciation “repayment” (“make amends gain”) is taxed at the same rate

which you were at when you took the deduction○ Want to retain integrity of “make amends” concept

Ex. Bought asset for $10k. Took depreciation deduction of $10k, and basis is now $0. If you sell for $10k, NO loss in value. [$10k(AR) - $0(Basis) = $10k(Real. Gain)]

● Took depreciation deductions on false premise! The asset did not lose value!○ When you sell: need to “make amends gain”

● Taxpayer took the depreciation deductions at 35% Rate.● Does taxpayer “make amends gain” use gain capital rate (@ 20%) or ordinary gain marginal

bracket rate?○ $10k deduction at marginal bracket of 35% worth $3,500 savings.○ $10k deduction at capital gains rate of 20% worth $2,000 savings.

● Using 20% Capital Gains rate wouldn’t fully make amends ● Deduction was used at Ordinary Gain rate - Recaptures Deduction should be at the same

rate!!

● NOTE: If he sold for $12k. Realized Gain = $12k.○ Maybe:

■ $10k of the gain is Depreciation Recapture @ 35%.■ $2k of the gain is Capital Investment Gain @ 20%

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