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Federal Income Taxation 12/5/12 10:50 PM
Introduction: Setting the Table
Sources of Tax Law:
Internal Revenue Code/ Title 26 of the US Code
o Positive law
Treasury Regulations
o Not positive law, but explanations of the Code provisions
o Highly regarded
Revenue Procedures
o Does not interpret or explain the code, but is there to do the mechanical
calculations required by the IRS (e.g. inflation adjustments)
Revenue Rulings
o Advisory opinions
o Designed to look and read like judicial opinions but without the names of any
taxpayers
o Released by Treasury lawyers
o Usually given a great deal of deference
Private Letter Rulings
o A taxpayer writes to the IRS laying out the facts of their case and a question; the IRS
answers that question
o IRS says these deserve no deference because each decision only applies to that
taxpayer; in practice, a PLR in your favor is very persuasive.
Common Law
o Intent of Congress is especially important for tax
Committee Reports are often used to determine congressional intent
o Because the issues are statutory rather than constitutional, Congress rather than
SCOTUS has the last rule.
o Substance dominates form
Without this people would start to believe that if they had good lawyers
they could basically get away with tax evasion; this doctrine says the courts
are going to call BS where they see it, technicality or not.
Definitions:
Tax base: the “thing” that is taxed (e.g. income, property, sales, consumption, estates,
wealth)
Tax incidence: who really pays any given tax?
Tax gap: the difference between taxes legally owed and taxes actually paid
o Can only have estimates, but approx. $500B more could be collected if people paid
all the taxes they owe.
Cross reporting: two parties with opposing interests reporting tax-relevant data to the IRS
o The average worker is a classic example: employer and employee are at opposing
sides and are both reporting the income to the IRS
Income effects: changes in behavior induced by the fact that the tax reduces the money
available to the tax payer
Substitution effects: changes in the behavior that arise from a change in the relative
attractiveness of different commodities or activities
Head tax: a tax of an equal dollar amount on everyone, or at least each person above a
certain age
Ability to pay: the attribute that might justify requiring some people to pay more tax than
others.
o The broader view looks at people’s material well-being without regard to liquidity
Marginal utility of income: the wealthier you are, the less each dollar lost to the tax
collected diminishes your well-being.
Endowment or wage rate (the rate at which one can earn money): the opportunity to earn
wealth whether or not exercised.
o This is so as to avoid possibly discouraging the exercise of wage-earning ability to
avoid paying taxes.
Cash-flow consumption tax: simply an income tax with a deduction for savings and with the
inclusion in the tax base of amounts drawn down from savings and used for consumption, as
well as amounts borrowed for current consumption.
o Seen in IRAs (individual retirement accounts) – amounts set aside in an IRA for
retirement are currently deductible in computing the amount subject to taxation
and amounts withdrawn from the IRA account are included in the income in the
year of withdrawal.
Imputed income: the value of goods and services provided to oneself.
“To the extent”: by the amount
Stock variable: variable whose value is not determined with reference to the passage of time
Flow variable: variable whose value is determined with reference to the passage of time
Tax evasion is illegal
Tax avoidance is legal
Tax Facts:
Allowed by the 16th Amendment, adopted in 1913: “The Congress shall have the power o lay
and collect taxes on incomes, from whatever source derived, without apportionment among
the several States and without regard to any census or enumeration.”
Income taxes (corporate and individual) are expected to produce 56% of total federal
revenues
Income taxes are also an important source of revenue for state government
The most common filing statuses are consistently “unmarried individual” and “married
individuals filing a joint return”
In theory, income taxes should produce both income and substitution effects
Using the tax system to deliver a subsidy allows its advocates to label it a “tax cut” rather
than a “spending increase”
Major Areas of Cheating:
o Cash businesses: small businesses are a huge part of the tax gap (big businesses
have incentives to be careful with accounting; the largest corporations are under
permanent audit)
o Underreporting of gains on securities – there is no cross reporting on the difference
between bought and sold
Tax Expenditures (refer to chart on Table 1-2 on p.17)
o Tax expenditure budget: certain tax benefits are equated with direct subsidies
o General approach is to identify various exclusions, deductions, deferrals, and credits
that are seen as departures from a neutral concept on income taxation; then to
figure out the cost of these special provisions; then to attribute these costs t various
budget functions.
o This budget wholly ignores features of the current income tax that are arguably less
favorable to taxpayers than pure income tax.
o The net effect is the same if you have a subsidy or if you collect more, then spend
Tax Law:
What happens when people violate the tax law?
99% of actions and punishments are civil
It is very rare for people to actually go to prison for tax evasion, the mens rea is very high.
The punishment often boils down to how long it took you to correct the mistake and how
big the mistake was
o Interest ≠ punishment, it is just putting you in the position you would have been in
had you paid.
Litigation is called “tax controversy”
o Always US v. Taxpayer
o Standard: preponderance of the evidence
o OIC – offer in compromise = a settlement
Jurisdictional Framework:
o Courts of original tax jurisdiction: US District Court, US Tax Court (created by
Congress under Art. I power), US Court of Claims
o If you want to appeal a Tax Court ruling, you go to the US Court of Appeals for your
circuit
o If you want to appeal a Claims Court ruling, you go to the Federal Circuit and then
SCOTUS
What is Income?
Y = C + S (Y is income, C is consumption, S is saving)
Haig-Simons: Y = C + ∆W (∆W is change in net worth) (each defined in terms of market value during
some specified accounting period)
Some characteristics of income
Noncash benefits
Why tax?
o Horizontal equity (treat likes alike)
o Our economy would move toward a barter system if noncash/ fringe benefits
weren’t taxed
Old Colony
o An employer’s payment of federal income tax on an employee’s behalf is income
o It’s the reason we have withholding – the employer Is paying on your behalf
o Grossing up: negotiating with your employer to pay income taxes – you have a
target after tax net income
N = G(1-t) where N = net pay; G = gross pay; t = tax rate
G = N/(1-t)
If you cross an upper limit of a bracket with the gross income, it becomes
more complex
Bengalia (p. 52)
o Tax years in question are the worst years of the Great Depression
o Bengalia was the manager for 2 hotels – he and his wife lived and took all their
meals at one of the hotels
o He was supposedly on constant duty and that is why he needed to live at the hotel
For the convenience of the employer
o Legal distinction: if you receive compensation that is valuable, there is a distinction
if it is for the convenience of the employer, it is not taxable
Comes from Reg. §77.
o Dissent: claims that the employee cared enough about living in the hotel that he
negotiated about it; Majority says the employer said he had to live at the hotel and
that’s good enough.
o Dissent looks at the fact that he’s managing multiple properties and can’t be at all
places at once, therefore convenience of the employer argument fails
o Both sides read “convenience” to mean requirement
o BTA creates common law by following the Reg – “convenience of the employer” test
is now law
Dissent holds that the question is really whether or not he benefitted from
the room and board. It doesn’t matter whether or not it was for the
convenience of the employer – the Bengalias received something with
market value.
Valuation under Bengalia
o If the dissent had won, the Bengalias would litigate the value of the benefit
conferred
Try for wholesale and not retail prices
Objective valuation of the horizontally equitable transaction – how much
would a 3P in an arm’s length transaction have had to pay for all the
Bengalias received?
Statutory aftermath
o §119: modifies the Bengalia ruling a little: the meals must be eaten on the business
premises; the lodging on business premises must be a requirement of employment.
More specific requirements are enumerated.
Illustration of §119(d)(2) in notes 17/9
o §132: Congress says the tax treatment of noncash benefits needs to be regularized
because it’s chaos – the give a list of fringe benefits that are not going to be taxed
Loss aversion
De minimis fringe is the default hail Mary to try to exclude
All have a non-discrimination rule
If you have a non-excludable fringe benefit, you use market value for
valuation
Look to Regs §1.61-21
Safe harbor rules: rough justice situation – you may not get FMV right, but if
you follow the rules, at least you won’t crash into the rocks
o §125: Cafeteria plans
Has a lot in common with §132, but must be properly organized into a plan
to be labeled as such
Doctrine of constructive receipt: substance over form rule
You don’t have to be taxed on the substance of the cafeteria plan because
you can always opt for cash instead
List is at the bottom of CB p. 62
“Use it or lose it” rule is a limitation on fringe benefits
o Turner
Family of four who won a radio contest for steamship tickets from New York
to Buenos Aires. Switched his two first class tickets for four couch tickets to
Rio for a small change fee
They wouldn’t have been able to take a trip like this but for the contest
The question is the value of the tickets to the Turners – neither IRS nor
Turners call it income.
Modern rule: objective valuation – not subjective because tax
administration should not “be based on anything so whimsical”
There is no Turner Rule
o Some unusual forms of income:
Realization:
Professors get free text books – no taxes unless they are turned into
cash
Catching historic home run balls – if you catch and keep or give
away, no tax; if you sell it, tax.
Specific employees can get freebies but turn them down – it is
income if you use the tickets
To solve the taxation problem for gifts/ promotions, you just need to gross
up
The other sure way to avoid taxation is not taking the prize
Imputed Income
Windfalls and Gifts
Glenshaw Glass (p. 78)
o Both companies received punitive damages and compensatory damages
o Compensatory damages are definitely taxable because they would have received
that income had they not been wronged
o In the lower courts, the taxpayer won against the IRS
o SCOTUS believed Congress was very broad in its definition of income and counted
the punitive damages as taxable income
Explicit exclusions: Gifts - §102 o Duberstein (p.83) (two consolidated cases trying to define gift)
Duberstein and Berman: professional relationship; D buys from B but often
offers advice on who might be a good customer when they don’t buy. B
gives D a Cadillac as a gift in recognition for all his help with extra clients. B
writes it off as a business expense even though he told D it was a gift.
Stanton: executive overseeing Trinity Church’s financial and real estate
holdings. He quits/ is forced out and the Church gives him a year’s salary
called a “gratuity” but says it’s for services rendered. Church says it’s giving
him the money because it likes him.
SCOTUS says in defining gift for tax purposes, they are going to use the
colloquial meaning.
It is the donor’s intent that controls
Gifts are when you don’t get something in return – can’t be a deal,
not services rendered or an anticipated benefit
It is from “detached and disinterested generosity” (p. 86)
IRS wants to make a per se rule that businesses can’t give gifts; SCOTUS
rejects this, and they won’t go so far as to say that the deduction by
businesses of the purported gifts is dispositive in making them non-gifts.
SCOTUS believes the donee should not have its tax consequences
based on what the donor did – instead it’s dependent on donor’s
intent
Duberstein: definitively not a gift.
Stanton: more complex because of the lower court’s ruling of “just a gift” –
SCOTUS willing to give a lot of deference but the trial court need to at least
explain. Stanton wins on remand.
Makes trial court’s decisions essentially non-reviewable
§102(c) would make Stanton lose automatically
§274(b) would make Duberstein less likely to get the gift because Berman
would have only been able to deduct $25
o Harris (p. 91)
Question of whether the money he gives the twins is income or gifts
Harris was convicted of criminal tax evasion by the lower court
If Kritzik wasn’t paying them income then he should have paid a gift tax
Threshold issue for Conley is if she was required to file income tax returns if
this was her only money – then, because it’s criminal, did she have the mens
rea? The court finds it was a gift and not income, therefore she didn’t need
to file the forms
Court finds the USG didn’t meet its burden
Harris: again, mens rea is lacking – the correct question is the donor’s
intent, so if Harris believed K loved her and that’s why he gave her the
money, it’s a gift. Court dismissed criminal charges.
General takeaway: for longer term relationships with a mistress where
money is exchanged but not on a transactional basis, those tend to be gifts.
If money is the exchanged each time sex is exchanged, it’s income
(prostitution)
It doesn’t matter how Harris or Conley felt, it only matters how they
believe/ have reason to believe K felt about them (Duberstein: donor’s
intent)
o Tips and unusual gifts:
Ordinary tips: IRS issued Regs – tips are income in the ordinary course of
business, but they created a safe harbor (10% of gross receipts), but the
employer has to provide gross receipts for when the employee worked, so
they can get their safe harbor income
Gambling tips to dealers, etc at casinos are income, not gifts, because the
intent is not generosity, it’s hope for luck
Welfare payments are not income
§117: Scholarships: in almost every case there is a zero bracket question/
issue
o Taft (p. 104)
Taft maintains she only owes $3000, the difference between the price of the
stocks when she received them and when she sold them. IRS says it’s
$4000, the difference between the price when bought and when sold –
doesn’t matter who bought them or that they changed hands
The 16th Amendment does not prevent “surrogate taxation” – collecting
taxes from one person on another’s behalf
Whoever has the asset, if they sell it, they face the tax
consequences
Carryover (substituted) basis/ transfer basis
Gain = proceeds - adjusted basis
Basis is usually the purchase price
§1015:
You take the basis from whoever gave you the gift
Except if the basis is greater than FMV at the time of the gift
(so that people won’t give loss properties in tax strategic
ways)
Example:
o Donor paid $1500; FMV at date of gift: $1000
o If recipient sells later for $800
800 – 1000 = -200 (discourages the gifting
of loss properties)
o If recipient sells later for $1600
1600 – 1500 = 100 (even though there was
originally a loss, the exception is only used
to calculate if selling for a loss
o If recipient sells later for $1200
Answer is 0 gain because §1015 math
doesn’t work – paradox
If high tax bracket guy has a gain – lower tax bracket gift
If high tax bracket guy has a loss, he can realize it and absorb it
better than lower tax bracket guy.
o Transfers at Death
Vertical equity question: you need to collect the same amount of taxes but
you might be collection them from a different set of people
Current state of the law:
§1014
Inheritance tax ≠ estate tax
Base is the recipient – amount of money received from
dead people – US does not have that
Estate: base is measured by money left after creditors have
been paid – measured/ taxed at giver rather than recipient
level
§1014(a)(1) treats you as if you’d paid FMV that day – death is not a
realization event; “step up in basis at death”
Means the decedent wants to keep shares that have gone
up in value and sell shares that have gone down
Decedent can borrow against unrealized gains
All kinds of generous estate planning opportunities built
into the tax rules
Currently:
$5M per spouse exception
35% bracket above that (positive taxable estate)
Default:
$1M per spouse exception
45% and 55% brackets
Policy rationales:
Why have an estate tax?
The most progressive of US tax laws
Allows for lower rates on other things
Acts as a back up capital gains tax
Encourages high wealth people to give to charity
Helps reduce the transmission of dynastic wealth
Why collect the tax upon death?
It is not a tax upon death because 99.7% of people die
without paying it
We don’t tax this during life because there can be reversals
of fortune in life – can assess once and for all ability to pay
Unreasonable attacks:
Double taxation: taxing the same basis twice – it is not
about a dollar being taxed, it is about an activity being taxed
Breaks up family firms and businesses – no evidence
Death tax and therefore immoral
Plausible attacks:
Administratively burdensome
Wrong to tax wealth that has accumulated from saved
income (moral argument)
Taxing wealth creates bad incentives
o Sometimes when you tax things, you encourage
them – “the income effect”
o Compared to what? Vertical equity question –
income v. wealth
Alternatives:
Get rid of estate tax, but also eliminate §1014 and declare
death a realization event – this would collect about 50%
more revenue than the estate tax
Get rid of estate tax, elimitae §1014, but don’t make death
a realization (you only have to pay if you sell the stocks) –
this would be a revenue loser
Loans and Discharge of Indebtedness
Discharge of indebtedness is the same as cancellation of debt
Loans are not income
o Selling bonds is borrowing money
o Buying bonds is lending money
DoI income = the reduction in the amount to be paid by borrower to lender §61(a)(12)
When a business borrows and issues bonds and must pay interest on those bonds – the
interest is deductible as a normal cost of doing business
o Not deductible for individuals
Kirby Lumber (p. 147)
o Issued $12M in bonds in July 1923; later than year, they extinguished $1M of
principle by paying $826k
o IRS claims the $138k is DoI income
o Court says “accession to income in the year” – income is income, this is not a tough
question
o Kerbaugh Empire muddies the waters because it seems Kriby’s refenence brings in
the overall story/ fate of the enterprise matter
In order to answer the DoI question, you need to know what happens to the
business
Courts have not treated this as true. They make Kriby as simple as it seems.
Fate of of enterprise is irrelevant.
Was a profitable exchange on the currency exchange market, there was no
DoI (Kerbaugh)
§108o This section is explicitly excluded from §61(a)(12)
o Insolvency (defined in §108(d)(3): if you have a negative net worth), you may not
even know if you’re insolvent, as opposed to bankrupt.
o Qualified farm indebtedness §108(g) – Congress loves farms
o Qualified principal residence indebtedness – added in response to the housing
collapse because so many people were foreclosed upon. Really almost all of these
people were insolvent anyway, but this now takes precedence over the insolvency
solution
o (e)(5): purchase money debt reduction for solvent debtor treated as a price
reduction
I lend you money to buy something from me
You come back and tell me you can’t pay the full price, if I allow a lower
price, the agreed upon payment is treated as the original purchase price
o (f) student loans: as long as you follow certain rules, you can pay less than you owe
without DoI income tax.
Zarin (p. 150)
o Basic tax treatment of gambling:
You can never deduct net losses
You do get taxed on net winnings
Winnings/ losses on either side of the calendar year cannot be offset (if you
won $1M at 11:58 on Dec 31 and you lose $1.2M on Jan 1 – you get taxed
one the $1M and can’t offset with the loss.
o Z was $3.435M in debt which he settled for $500k; the IRS says the difference of
$2.935M is DoI income.
o Majority finds this does not represent DoI income in two ways:
Claim that this was not indebtedness at all (even though their definition of
indebtedness is taken from §108(d) and that plainly states it does not apply
to §61)
The fact that Z paid them $500k undermines the idea that he didn’t
owe them money
Property analysis: Casino chips are not property
Only USG can create money
Claim this was like the negotiated price of a product (negotiation fixes value)
$3.4M was never what was owed because the parties agreed and
accepted $500k, therefore that’s what was always owed and there
is no DoI income.
Liquidated damages – the amount was known; unliquidated
damages – the amount was not known
The majority acts like this distinction doesn’t matter theat
whatever the settlement is is the correct amount and
always was – this is not true.
Gain on sale of a home
Old rule, repealed in 1997: §1034 – could exclude all gain if you buy a house with a higher
price within 2 years; at age 55, there was a one time exclusion up to $125k
New rule: §121o $250k/ 500k exclusion (single/ joint) “every 2 years”
o Gains in excess of exclusion amount are taxed as capital gains (15%)
o Only applies to principal residences (totality of the evidence for determining
principal residence) – can only have one principal residence at a time
Safe harbors (§121(c)(2)(B)
o Unforeseen circumstances
Multiple births
Divorce
Inability to afford the residence
Adult child moving back in
o Preference for another location is NOT excludable
o The exclusion is not 250/500 though, it is:
N. of months as principal residence/ 24 months = allowable exclusion/
250k/500k
§121(f): election to have section not apply
o If you plan to sell multiple properties, you should elect not to deduct the smaller
gain
o It’s a planning tool
No deduction for losses on the sale
o You don’t want to encourage people to sell their house at a loss for tax purposes
Congress sees houses as piggy banks – unless it grows by too much, it’s tax free
Perverse incentives
o If you have a vacation home, you have incentive to turn it into your principal
residence for §121 purposes
o Planning which home to take a deduction on
o If you’re in an expensive region during a boom, you are incentivized to just jump
from one expensive house to another because they were at or near the exclusion
mark.
Annual accounting and its consequences
Sanford & Brooks
o Dredged the Delaware River
o S&B stopped work; USG says they won’t pay for any of the work done so far because
the k is breached
S&B hit rock on the bottom of the riverbed, that breached the warranty
In 1920, S&B wins its suit against USG – they are awarded $192k, which
includes their work and interest (the interest is definitely income)
o S&B argues that the payment for work just makes them whole, it’s not income, it’s
just counterbalancing their losses in 1913, 15 and 16
o SCOTUS distinguishes between transactional and annual accounting
Transactional: you don’t determine taxability until the transaction is
completed
Annual: you just account for each year’s revenue
o SCOTUS holds that when you receive money in a year, it is taxable in that year
That is what Congress meant to do – not saying it was the right choice, just
that it was their choice
o Huge horizontal inequity
o S&B is a constitutional challenge
We never earned income, so you can’t charge us income tax
SCOTUS says they can
Congressional reaction:
o Refundable or negative taxes: Congress decided not to pursue this option. Instead,
they act as if business expenses are much higher than they are.
Accelerated depreciation schedules: in no way reflect reality but that’s the
purpose.
o §172: net operating loss deduction
If you find you’ve got a loss in a given year, it takes your taxes down to zero
Says you can take your loss and utilize it to offset gains in another year. You
can either go back 2 years or forward 20 years
Supposed to allow businesses to reflect how well/ poorly it is
actually doing over its life rather than over a year
(d)(3) says you can’t include personal exemptions
(d)(4) says you can’t include non-business deductions – it’s designed to help
businesses
(b)(3) gives you two options:
Go back to years then forward until you run out of money
(sequentially) – default option
Only go forward
North American Oil Consol. (p. 132)
o Trying to pay taxes early because the tax rate went up substantially
o NAO drills and extracts oil on USG-owned land
o USG sues for ouster, receiver holds the money pending the outcome of suit; in 1916
NAO is awarded $172k, but USG continues appeals until 1922 when they lose.
o IRS sues NAO for 1917 returns, NAO had amended its 1916 returns in 1918 and filed
them appropriately
o BTA says 1916 is the right ear and the receiver should pay the taxes; Appeals says
1917 is the right year and it’s taxable to NAO – SCOTUS says it’s not taxable to the
receiver in this case (the receiver was an unimportant middleman) – it is income for
NAO.
o It’s not income in 1916 because the suit was ongoing and its outcome uncertain.
NAO is trying to make an accrual-like statement, but court finds both the cash and
the accrual transactions took place in 1917.
o If USG had won in 1922, NAO could have taken a deduction for the award
o Two part test: (harsh rule, similar to S&B) (p. 134)
Claim of right – receives without restriction as to its disposition, he has
received income, even though it might be taken away later
Cash
§1341: Claim of right
o You don’t have to worry about statute of limitations
o Basically is the exact opposite of Lewis
Lewis (p. 136)
o Lewis receives a $22k bonus in 1944, then he realizes the mistake and pays back
$11k in 1946. He wants to take the loss reduction from his 1944 taxes; IRS says no,
he can deduct from 1946
o Lewis wins below, but NAO test clearly states IRS is right (claim of right and cash)
o Douglas’ dissent appeals to equality; he says you can either be final or be right, and
in this case they can be right.
Embezzler is allowed to deduct restored income if it’s in the same year – but if you don’t get
caught until a later year, there is no deduction
o Tax incentive to fess up if things look like they’re going downhill
Income averaging: would have people keep track on an ongoing basis so that if there is
something that affects other years it’s taken into account
o Lifetime income averaging: cumulative income over the whole earning lifetime
o Based on a concept of horizontal equity – because some years fluctuate income, so
people may be treated as rich when they aren’t or poor when they aren’t
o Vertical equity also implicated
Tax benefit rule (p. 139)
o Deduction in an earlier year that later becomes clear you didn’t deserve
o §111 want to rule out the worst injustice
If you got any benefit at all §111(a) isn’t going to help you
o There are times when a deduction is alive in an NOL - §111(c)
If it’s alive, you don’t get the benefit of TBR
o Administrative convenience rule: taxpayer takes deduction he shouldn’t have, the
question is when to take it and how much to deduct
Alice Phelan (p. 140) – just include the amount you deducted before
Claim of right doctrine:
o NAO says income in year received and under claim of right is taxable
o Loss in an earlier year, income in a later year? S&B court says tough luck
Congress passes §172: NOLs (2 years back, 20 years forward)
o Income in an earlier year and loss in later year? Lewis court says tough luck
Congress passes §1341: choice of deduction now or recomputation of an
earlier year
o Deduction in an earlier year, restoration in a later year?
Congress passes §111 (a) if no earlier tax reduction, then no later reduction;
(c) keep track of NOLs
When is income taxed?
Timing questions having to do with earning income but not having to pay tax on it yet
Why delay/ defer paying taxes?
Procrastination
Liquidity restraints
Time value of money: taxpayer has the use in the interim of the amount that would
otherwise have been paid in taxes
o You will always gain if you van put off paying your taxes and aren’t charged interest
o FV = PV(1+r)n (r = interest rate; n = number of years; FV = future value; PV = present
value) PV=FV/(1+r)n
Rule of 72 (doubling rule): how long will it take your money to double if interest rate stays
the same: 72/ I (where I = interest rate expressed as a percentage)
Why have realization and recognition doctrines?
Liquidity
Valuation difficulties (e.g. no one really knows how much their house is worth until they sell
it)
Nature of the asset is the same
Capital mobility (even though you’ve experienced a gain, the IRS does not want to stop you
from reinvesting in the best area for the general economy)
The realization doctrine
Income is realized when you sell an asset for cash
Eisner v. Macomber (p. 197)
o Constitution was amended in 1913 and 1916 with Revenue Amendments (16th
Amendment)
o Macomber has 2200 shares with a par value of $100/ share; FMV of between $360 –
380/ share
o Stock split: she was issued another 1100 shares, but the value was now between
$234 – 260/ share
o There is no change in wealth, it is simply a bookkeeping matter
o Government wanted to impose a tax on the par value of the new shares from the
stock split
o USG argument:
Stock dividend is income because it increased her wealth (clearly wrong,
she’s no richer)
Stock dividend is a realization event (Brandeis agrees)
Income that has not been taxed can taxed at any time (correct at the time,
but not true now)
o Court says income is a term of usage, not a term of art
They latch onto the word “derived” in “from any source derived” – they
decide it means for separate use and benefit
They focus on “separate” and say the stocks are the wealth – they would say
it’s not income until it’s realized income.
o Brandeis’ dissent: Macomber’s lawyers admitted the functional equivalent of the
stock dividend would be a realization event, therefore the stock dividend is a
realization event.
o It is not unconstitutional to tax unrealized gains
Under Macomber:
o Accrual based would mean Macomber would have to pay taxes every year on her
earnings
o Instead, Congress chose to create a realization requirement statute
Reasons for realization:
o Liquidity
o Valuation difficulties
o Divisibility – if you have property that taxes would force you to sell, general
speaking, you alter the nature of the asset if you divide it
o Variability – fluctuations in value would cause payments to go back and forth
between taxpayer and government if there was taxation every year
Helvering v. Bruun (p. 208) – non-sale realization event
o Realization is more than just selling something for money
o Lease for commercial property begins in 1915 and is supposed to go for 99 years
o In 1929, the old building is knocked down and a new building worth ~ $50k more
than the old one is built (income of $50k but not taxable to Bruun because he didn’t
have access)
o In 1933, lessee defaults and Bruun takes possession of the improved lot
o The Court holds that realization doesn’t just have to be a cash sale of assets
transaction
If it’s not a cash transaction then you need to look for “meaningful
moments”
Gain may occur as a result of:
Sale of an asset
Exchange of property
Payment of taxpayer’s indebtedness
Relief from liability
Other profit realized from the completion of a transaction
o Court holds Bruun had a “meaningful moment” in getting his land back with at $62k
improvement – it was a realization event and therefore was taxable in 1933 when
he got access.
Bruun Aftermath:
o §109: a direct reaction and a reversal of the Court’s decision
Buildings intended as rent have to be treated differently than a Bruun-type
building §1.61-8o §1019: you don’t get to adjust your basis upward as if you had taxes
o See chart on p. 212
Woodsam Associates (p. 213)
o Mrs. Wood bought the property with a mortgage that had recourse to her personal
assets. Years later, she refinances the mortgage without personal recourse.
o She calls that a realization event because the only thing the bank can take now is
the house (a $100k gain on selling to the bank)
o When she sells later she claims her basis is what she should have been taxed before
and she now has a loss
o Court basically says “you’ve got to be kidding” – the house was clearly hers and not
the bank’s – there is a limit to non-sale realization events
Cottage Savings (p. 216)
o S&L crisis
o Cottage Savings wants to deduct a loss – normally, to realize a loss you just sell your
assets at a loss. They have to book their loss and report it to the FHLBB, which
cannot then ignore their insolvency. Regulators don’t want the S&Ls to be insolvent
but they want them to get the tax advantage of deducting losses. FHLBB issues
Memorandum R-49 to allow S&Ls to recognize tax losses but not to properly report
them, exposing insolvency.
Allows asset swapping for “substantially identical” mortgages – identical in
substance
Ten criteria for classification (p. 217)
o Is this a realization event? (They swapped baskets of substantially identical
mortgages in order to realize a loss) §1001
Is this a disposition of property?
Is there a material difference requirement?
If so, is there a material difference in this transaction?
o Treasury Regs: In order to be a realization event, the assets must be materially
different (since 1934)
Differ in economic substance
o Court says yes, there is a material difference requirement
IRS says you look at what the regulator (FHLBB) says: they say the assets
must be substantially identical therefore they cannot be materially different
IRS also looks at the evaluation of the interests by the secondary mortgage
market
o Court finds the IRS’s test “complex and unworkable”; they find that different =
materially different
“distinct legal entitlements” satisfies the materially different test – as long
as the entitlements are not identical, the realization event Is allowed (which
is good for determining valuation)
o §1031: Like-kind doctrine – these properties can be very different, they don’t need
to be substantially identical
Court says if they used the IRS’s reading, §1031 would be moot and
surplusage
o §165 discussion: in the court below, the IRS won by arguing Cottage Saving’s losses
were not in the taxable year – Court is correct here.
o Dissent:
Look at what a rational investor would think looking at this investment/
basket of mortgages
“materially different” doesn’t matter to investors
FHLBB created this rule so as not to be indifferent to which basket
they had
In this case, the parties didn’t even keep track of the borrowers, the
borrowers kept paying the same rate
If there was a material difference, someone would have cared!
Cottage Savings Aftermath:
o “Hair trigger” standard: you love it if you want something to happen quickly and
easily; you don’t if you want to be careful/ deliberate
o Debt workouts: where distressed borrowers and their creditors agreed to certain
modifications of the underlying debt instruments.
Do they have to be treated as a sale or other disposition and count as a
recognition event post-CS?
o Taxpayer savings
o This decisions glories in form over substance – it set a very bad present
o Treasury Dept. had to clean up the mess “CS Regulation”
DOI income
They basically overrule CS
New TOA: “significant modification” – legal definition
Regs had to dial back the hair trigger
Nonrecognition provisions
Congress steps in and says, under certain circumstances, you can avoid paying taxes on
Haig-Simons income and realized gains.
Realization v. Recognition
o Realization: did something of significance happen to this property?
Sale or other disposition
o Non-recognition: you don’t have to pay tax yet if:
Realization transaction doesn’t generate cash
Gain/ loss might be difficult to measure (valuation problem)
Nature of asset is not significantly changed
Want to avoid discouraging mobility
§1031: Like-kind Exchanges – not substantially identical, but alike enough to merit non-
taxation at the time
o Exceptions:
Stock in trade or other property held primarily for sale
Stocks, bonds or notes
Other securities or evidences of indebtedness or interest
Interests in partnerships
Certificates of trust or beneficial interests
Choses in action
o What does it mean?
References nature or character, not quality or grade
Reg. §1.1031(a)-1: it is when the nature or property is the same (gives
examples)
Transfers incident to marriage and divorce
Transfers of cash (alimony) v. transfers of property
o Transfers of cash (child support) treated differently
Davis (p. 291)
o Divorcing spouses – husband transfers ownership of stock that has appreciated in
value during his ownership – is that a taxable event?
o IRS says yes, he was buying his rights out of the marriage – it had a lot of value for
him.
o He is buying inchoate marital rights – Davis says yes, but because they are inchoate
that value is unknown
It’s hard to know what she would have gotten in divorce court but we know
what he paid, so that is the value of getting his rights back
o Davis has a taxable income in the year of the sale/ transfer of stock and his basis. It
is NOT a gift.
o Treat transfers of property as a realization event for the one transferring to get
something in return.
o What is Mrs. Davis’ basis?
The FMV of the stocks the day they were transferred to her.
If Davis had won, Treasury would not have gotten its money, so Mrs. Davis’
basis would be whatever Davis’ had been – treat it like a gift with carryover
basis.
§1041: mirrors §1015 – a non-recognition rule that treats the divorce property transfer as a
gift
Farid-Es-Sultaneh (Mercer) (p. 296)
o Pre-nup requires her to relinquish all rights to support and other marital rights (she
cannot sue him in divorce court). Mercer gives up “really inchoate marital rights” –
she gives them up even though she doesn’t yet own them because it’s pre-nuptual
o Pre-nup identifies the stock as a “gift in consideration of . . .”
o When Kresge transferred his shares, they were worth $10/ share (he had a basis of
$.15), when she sold them they were $19/share
She claims a $9/ share gain; IRS wants her to have an $18.85/ share gain
o IRS says this looks like a transaction contract rather than a gift
o Court find that the IRS should have taxed Kresge $9.85/ share when he transferred
them but they didn’t, now Mercer has a basis of only $10/ share.
o Grossly inadequate consideration – she sold ~$125M of really inchoate marital
rights for less than $1M. If looking at this as a contract issue, this is important but
the rights are really inchoate, so they might have become non-existent without this
agreement.
o The rest of the taxpaying public did get cheated, but not beasue or Mercer, because
the IRS did not tax Kresge when he transferred the shares to her.
What’s wrong with the Davis/ Mercer logic?
o Tracking basis becomes more and more absurd
o What are inchoate marital rights? Who has them? What are they worth?
Look at chart in class notes 5/11 ***
How can taxable income and taxes be reduced?
Hierarchy of tax reduction techniques (from most to least taxpayer friendly – keep in mind that above
the line is always better than below the line, and both are available for the last four):
Credit (refundable is better than non-refundable)
Expensing – deduct the cost of things in the year in which they happen
Depreciation (accelerated methods preferred)
Addition to basis
Nonrecoverable
Personal deductions
Zero bracket is more complex
Extraordinary medical expenses
o §213: sets a high threshold (7.5% of AGI) and only deductible to the extent that it
exceeds 7.5%
o Can plan for extraordinary medical expenses with a flex account, but if you don’t use
it, you lose it
o Employer can deduct employee’s health insurance and the employee doesn’t need
to count it as income
o Taylor (p. 351)
Has some allergy for which him MD told him not to mow the lawn. He hired
a service and tries to deduct the cost under §213.
§262 says no personal deductions and IRS finds that §262 trumps §231
Taylor’s burden to prove that he wouldn’t have hired someone to mow the
lawn anyway – he didn’t meet that burden
The court is trying to police a very blurry line due to the very broad
definition of “medical care” in §213
Just because an MD prescribes it doesn’t mean it counts as a
medical expense
o Ochs (p. 352)
Mother is very sick, so they sent their children away to boarding school and
tried to deduct tuition as a medical expense. The tuition was roughly ¼ of
the family’s income, so they were unlikely to have sent this children away
but for the mother’s illness.
IRS says the tuition was a personal family expense and is non-deductible
The school is replacing the mother’s caregiving role
The whole family benefited, therefore it was not a medical expense
Dissent:
Says the ruling seems to indicate the expenses for sending the
mother away from the children rather than vice versa would have
been deductible.
Judges should use their common sense
Says test should be:
Would the taxpayer, considering his income and living
standard, normally spend money in this way regardless of
illness?
Has he enjoyed such luxuries or services in the past?
Did a competent physician prescribe this specific expense as
an indispensible part of treatment?
Has the taxpayer followed the physician’s advice in the most
economical way possible?
Are the so-called medical expenses over and above what
the patient would have had to pay anyway for his living
expenses (that is room, board, etc.)?
Is the treatment closely geared to a particular condition and
not just to the patient’s general health or well-being?
Limit the deduction to the least expensive option – for example,
only have the deduction for when the children would have been
around their mother.
Charitable Contributions
o §170: Deductions (for the use of the donor)
(c) defines charitable contributions – donations abroad are not wholly
deductible
(f)(12) used motor vehicles, boats, and airplanes
o §501: Charitable organizations (they don’t have to pay tax)
(c)(3) almost exactly the same as §170 definition
Private inurement restriction
No electioneering
o §527: organization is taxable on the income it receives but the contributions people
give are not taxable
o What happens when the contribution isn’t money:
Capital gain that has been neither realized nor recognized (or just not
recognized)
If the piece of property has been held for more than a year, you can
donate it without realization or recognition (long term capital gain
rule) – can deduct the full fair market value
If held for less than a year, you can only deduct the basis (short
term capital gain)
o Corporations get deductions for charitable giving too, they are very important
sources for charitable giving.
Ottawa Silica Co.
Donated 50 acres to the school district with the expectation that
they’d be able to utilize the roads the school would build.
The local government is a charity under §170(c)(1)
IRS claims it is not a charitable deduction because they did it with
the expectation of a return benefit to such an extent that the
benefit was probably their motivation
Ottawa Silica received more benefit than anyone else in the
community – it was a substantial benefit
Was it quid pro quo?
Relevance of intent? Intent is not required
If a supposed charitable giver receives or expects to receive
substantial benefit
DuVal says the test is not substantial benefit but dominant or primary intent
test
If you fail the test (either DuVal or Ottawa Silica) there is no deduction – it’s
all or nothing
o Private benefits: (for non-businesses)
Not all or nothing like with corporations – there is a partial reduction rule –
you can still deduct the amount of your contribution that didn’t get you a
substantial benefit.
De minimis rule: trivial benefits don’t count (e.g. the swag from PBS
won’t be counted against your deduction)
o Special case for college athletics §170(l)
Universities are basically charging seat licensing fees – donors have to make
a contribution to a scholarship fund in order to get on the list to buy season
tickets
The buyers/ donors can deduct 80% of their contribution even though it’s
clearly a quid pro quo contributions
o Bob Jones University
Has had very limited practical impact on the tax law
Racial bias in education and they want to keep their charitable status
District court says the IRS exceeded its authority by issuing the rule, that it
violates the first amendment . . .
Court of Appeals says charities with §501(c)(3) status must not go against
public policy
Bob Jones argues there is no public policy requirement in the law
SCOTUS finds there has always been an understanding that public policy
benefits are required as part of being a charitable organization
By giving them §501(c)(3) status, we are giving them public money
to play with, therefore they need to not violate public policy – their
charitable deduction implicates all taxpayers.
If the Establishment Clause was brought in as part of public policy, then no
religious organization could be a charitable organization
Powell’s concurrence ends up winning: There must be no doubt that the
charity violates a fundamental public policy (in this case Brown v. Board)
IRS always has the power and authority to make the kinds of decisions made
in this case (denial of §501(c)(3) status based on their interpretation
Also, Congress had the ability to change the IRS’s decision/
interpretation and they didn’t, therefore they agreed with the IRS.
Personal exemptions and credits
Mixed business and personal deductions (open to a lot of fraud)
§162: businesses can deduct the cost of doing business
§212
§262: disallows deduction for personal expenditures
§67: basically transfer §162 to the individual, creates a 2% of AGI threshold – miscellaneous
itemized deductions can be aggregated, except for those listed in (b)
§183: hobbies
o Nickerson – very fact specific
§280(A): deductablity of the use of one’s home for business use
o Popov
Earned Income Tax Credit (p. 384 – 386)
Office Decoration: Henderson
o She got a bare bones office from the state. She bought a plant and art for her office
and bought a parking spot (for the times she couldn’t use a car service)
o Claimed the office decorations were for the good of both her and her clients
o There needs to be sufficient nexus between petitioner’s expenses and the carrying
on of petitioner’s trade or business in order to qualify for §162 deduction – it must
trump §262 in order to qualify
Must be more than a little helpful in carrying out the business and cannot be
for the personal enjoyment of the taxpayer
o If she was in private practice it would almost always be deductible.
o Court found they were not deductible.
Travel and entertainment expenses
o Rudolph
Reward trip to NYC for TX salesman and his wife.
IRS finds the trip is income – basically a non-cash fringe benefit –
compensation for a job well done (§61). Rudolph gets no deduction.
Primary purpose test: District court found that the primary purpose was
pleasure, as such, it falls under §262 as a personal expense.
Crucial question is whether or not it was related to business
Rudolph claims he was required to go in order to further his career
Court found no compulsion
Harlan basically says §162 can be satisfied without trumping §262
Dissent:
Claims programs like this have no rational connection with services
rendered
There are no earmarks of a sham
Wives:
Currently, §274(m) expressly denies deduction for the dependent’s
travel expenses
This was easily deductible for the company.
Clothing expenses
o Pevsner
Worked at YSL and was required to buy YSL clothing for her job. She wants
to deduct the purchase of the clothes.
Tax Court said yes; 5th Circuit says no.
Three prong test (clothing is deductible if):
Specifically required for employment
Not adaptable for general usage
Not worn for general usage
There is an objective test and a subjective test – the subjective test is not
administratively feasible and it is not fair (horizontally inequitable)
Courts always prefer objective tests
They don’t want the deduction to depend on the taxpayer’s lifestyle
It doesn’t matter that she never wore them outside of work, it matters that
she could
Expenses of Education
o Carroll
Chicago PD detective tried to deduct his college tuition as a business
expense
CPD encouraged its police force to get a college degree – they created
special flexible schedules to allow them to go to class
Carroll was a pre-law, philosophy major
Reg. §1.162 determines whether tuition is a deductible expense
Establishes a more objective test: maintains or improves required
skills for the employment or trade
Must prove it is required, not just encouraged
Court says it is not their job to carve out exceptions – that is for Congress
o Congress’ Response (p. 463)
§222: provides an above the line deduction for “qualifying higher education
expenses” such as tuition, paid by the taxpayer during a taxable year
Subject to notch and cliff: Maximum deduction of $4,000 for
taxpayers with an AGI of $65,000 or less ($130,000 for joint
returns); maximum deduction of $2,000 for taxpayers with an AGI
between $65,000 and $80,000 ($130 – 160,000 for joint returns).
Above that, you cannot deduct.
Depreciation
Definitely a deduction – you want to correctly measure income
Some assets waste over time (they wear out) so you want to measure the decline in value to
better accurately report income.
Expensing means you can deduct all of the costs of a wasting assets as if it would be gone
over a year
§168 - Accelerated Cost Recovery System: allows businesses to understate their income and
be undertaxed (this is a subsidy of investment in manufacturing/ capital assets)
o Deliberately measure it incorrectly so as to hopefully fund further investment and
growth
Determine:
o The useful life of the asset
o The salvage value (what it is worth at the end of its useful life? – generally speaking,
the salvage value is 0)
o Set an allocation method
Allocation Methods:
o Straight line method = (initial cost – salvage value)/ useful life
o Double declining balance method (front loading) = 2(straight line method) but only
on remaining undeducted value
This method recognizes that the asset declines in value in a non-linear way
Congress has chosen this useful life of most things with §168(e)(3)
Investment tax credit directly rather than indirectly subsidized some kind of investment –
basically, if you buy certain assets, the government will give you a tax rebate for a certain
percentage of it.
The Alternative Minimum Tax (§55-58)
A backup tax system
Not indexed to inflation, so Congress has to deal with it annually – needs constant “care and
feeding” or it does crazy things, Congress has gotten less good at regular care and feeding.
It takes a lot tax preferences used to reduce income then subjects that taxpayer to either
26% or 28% taxation – broadens the base
There is a large zero bracket
o $72,450 for couples filing jointly
o $48,450 for singles
Phase out of the zero bracket above $150,000 AMT Income
Two brackets:
o 26% for up to $175,000 AMTI
o 28% above (to the extent that is exceeds $175k AMTI)
AMT = TMT – regular tax, if positive
Preferences giving rise to AMT liability:
o Tax-exempt interest
o Percentage depletion
o Intangible drilling costs
o Research and experimentation costs
o Incentive stock options
o Itemized deductions: The amount of the preference is determined by disallowing
certain itemized deductions, including the deduction for state and local taxes, the
deduction for interest on home equity loans, and certain job related outlays, and by
limiting the deduction for medical expenses to the excess over 10% of AGI (as
opposed to 7.5% for normal tax)
o Credits denied: Certain tax credits, though technically not listed as preferences, are
lost for purposes of computing the AMT. This is accomplished by disallowing these
credits when computing the regular tax as a prelude to computing the AMT. The
limitations are found not in the AMT rules but the rules relating to credits (e.g. §26).
Beginning in 2012, the lost credits will include child and education credits.
o Heads of households
Taxpayers, going in, don’t know whether the AMT will increase their taxes
Klaassen (1999)
o Because they can’t deduct for all their children under the AMT, they qualify for
additional taxation
o They argue their rights (1st and 5th Amendments) are being violated
o AGI = $83,056
After deducting state and local taxes, medical expenses, charity, personal
exemptions, and medical expenses, their taxable income was $34,092 and
their tax bill was $5,111.
AMT doesn’t allow some of those deductions (and changes the allowance
for medical expenses from 10% to 7.5%), so their AMTI was $68,832
o Taxable excess = $68,832 – 45,000 = 23,832
o TMT = .26(23,832) = $6,196
o AMT = TMT – regular tax = $6,196 – 5,111 = 1,035
o Klaassens claim they shouldn’t have to pay because they aren’t the target – court
rejects this because Congress was very specific about who gets hit by the AMT
o Klaassens’ constitutional claims – the law has a general application that happens to
burden some religious dictates but does not violate their free exercise
o Dissent offers Congress a road map for fixing the AMT
12/5/12 10:50 PM
12/5/12 10:50 PM
