Federal Income Tax Outline

Fall 2005

Table of Contents1Table of Contents

3Abbreviations in This Outline

4I. Overview of Income Tax System

4A. Sources of Tax Law

4B. Tax Litigation

5C. Steps in Computing Taxable Income

5II. Ethics

5A. Standards for Tax Attorneys

51. ABA Formal Opinion 85-352

52. IRS Circular 230 Best Practices and Other Standards (31 C.F.R. 10.34)

63. Section 6694

6B. Standards for Taxpayers

6III. The Scope of Gross Income

6A. Cash Receipts: Does Source Matter?

61. Generally, No

72. Tax-Free Recovery of Capital is Allowed

73. Statutory Exclusions (Congress Says Source Matters)

9B. Is it taxable if it isnt cash?

91. Generally, Yes, as far as 61 is concerned

102. Two Great Non-Statutory Exclusions of Non-Cash Economic Benefits

103. Statutory Exclusions Based on the Non-Cash Nature of the Benefit

144. De Facto Administrative Exclusion Frequent Flier Miles: CB 213-221

14C. Income Inclusions as Mistake-Correcting Devices

141. The Annual Tax Accounting Period

142. Loans and Cancellation of Indebtedness

173. The Tax Benefit Rule

17IV. Property Transactions

17A. The Realization Doctrine

181. Eisner v. Macomber

182. Unrealized Appreciation, Stock Dividends vs. Cash Dividends

183. The Constitutional Issue

18B. Manipulation of the Realization Rules

191. The Substance of a Sale without Realization of Gain

192. The Substance of Continued Ownership with Realization of Loss

193. Cherry Picking 1211 Capital Loss Limitations

19C. Nonrecognition: CB 269

191. The concept of nonrecognition

192. Like-Kind Exchanges: CB 272; HB 220

203. Involuntary Conversions ( 1033): CB 277; HB 237

204. Permanent Exclusion of Gain on the Sale of a Principal Residence

21D. Installment Sales

21E. Annuities

22F. Basis Rules for Property Transferred by Gift or Bequest

221. Property Transferred by Inter Vivos Gift

222. Property Transferred at Death

223. Part Gift, Part Sale Transactions

22G. Basis Allocation: Piecemeal Asset Dispositions and Other Contexts: CB 294

23IV. Personal Deductions

23A. Charitable Contributions ( 170): CB 356; HB 519

231. The Rationale

232. The Amount of the Deduction

243. Eligible Recipients

244. Limitations on Deductions and Carryovers

245. Vehicle Donations

246. Quid Pro Quo

25B. Interest Expense: CB 363; HB 490

251. Qualified Residence Interest

262. Business Debt

263. Investment and Passive Activity Interest

264. Educational Loan Interest

26C. State and Local Taxes: CB 375; HB 498

27D. Casualty Losses: CB 382, 470-478; HB 500

27E. Medical Expenses: CB 388; HB 514

28F. Miscellaneous Itemized Deductions: CB 394; HB 527

28G. Reduction of Itemized Deductions for High Income Taxpayers: CB 395

28V. Business Expense Deductions

28A. What is an Ordinary and Necessary expense? CB 495

281. Necessary

282. Ordinary

29B. What is a Trade or Business?

29C. Public Policy Limitations

29D. Lobbying Expenses

29E. Reasonable Compensation

30F. Travel and Entertainment

301. Travel

302. Entertainment

31G. Patrolling the Business-Personal Borders

311. Hobby Losses

322. Vacation Homes

323. Home Office

324. Education Expenses

335. Work-Related Clothing

33VI. Capitalization and Cost Recovery

33A. Capitalization and Depreciation: The Basics

33B. What is Depreciable?

34C. What Costs Must Be Capitalized?

341. Self-Produced Property

342. INDOPCO

343. Repairs

344. Expenses to Create or Maintain a Business Reputation

355. Job Hunting Expenses

35VII. Tax Accounting

35A. Generally

35B. Cash Method: Constructive Receipt

35C. Accrual Method

351. All Events Test, Clear Reflection of Income, and Economic Performance

362. Early Cash Receipts of Accrual Method Taxpayers

36VIII. Tax Preferences

36A. Tax Shelters

361. Passive Loss Rules of 469

362. Judicial Anti-Abuse Doctrines

37B. Alternative Minimum Tax

37IX. Taxation and the Family

37A. Tax Allowances for Family Responsibilities

371. Allowances for Child Care Expenses

382. Child Tax Benefits Not Based on Expenditures

38B. Income Tax Treatment of Marriage

38C. Income Tax Consequences of Divorce

39D. Earned Income Tax Credit

39X. Identifying the Proper Taxpayer (Attribution)

39A. Earned Income

39B. Income from Property

40XI. Capital Gains and Losses

40A. Mechanics of Net Capital Gain Computation

401. Long and Short Term Capital Gains and Losses

402. Netting of Long and Short Gains and Losses

403. The Several Capital Gains Rates

414. Netting the Special Rate Categories

41B. Limitations on Deductions of Capital Losses

411. Rationale

412. The Capital Loss Limitation Rule

413. A Big Exception for Small Business Stock

414. Capital Loss Carryback and Carryover

41C. Definition of a Capital Asset

411. Property Held for Sale to Customers

422. Property Used in a Trade or Business

42D. Sale or Exchange Requirement

42E. Substitutes for Future Ordinary Income

Abbreviations in This Outline

CB Casebook

HB Hornbook

P Publication 17

I. Overview of Income Tax System

Unit 1: CB pp 1-2, 27-32 (skip chart on 28-29) and Introduction (HB pp 1-8)

A. Sources of Tax Law

The Internal Revenue Code subject to any constraints imposed by the U.S. Constitution.

Regulations promulgated by the Treasury Department. In some cases, Congress has delegated to the Treasury the authority to establish substantive rules (legislative regulations) rather than merely to interpret the Code (interpretive regulations). If a court believes that a Code provision could reasonably be interpreted in more than one way, the court will uphold any reasonable regulatory interpretation. Chevron U.S.A. v. Natural Resources Defense Council, 467 U.S. 837 (1984).

Revenue rulings and revenue procedures published by the IRS.

A revenue ruling sets forth the IRS view as to how the Code applies to a hypothetical set of facts. A ruling does not have a presumption of validity. However, a taxpayer may rely on factually applicable taxpayer-favorable ruling (unless and until the IRS revokes the ruling).

Revenue procedures have the same legal status as revenue rulings, but they resemble regulations in format

Letter ruling. For a fee, a taxpayer may request a private letter ruling from the IRS. The taxpayer submits to the IRS a description of the proposed transaction and the taxpayers argument as to why favorable tax treatment is warranted under the applicable law. If the IRS issues a favorable ruling, the taxpayer to whom the ruling is issued may rely on it, even if the IRS later decides the legal analysis is wrong. The difference between a revenue ruling and a letter ruling is that a taxpayers reliance on a letter ruling issued to another taxpayer is not protected.

The Treasury and the IRS rely on detailed reports from the House and Ways and Means Committee and the Senate Finance Committee in interpreting the Code.

Bluebook After the enactment of major tax legislation, the Staff of the Joint Committee on Taxation usually publishes a General Explanation (or Bluebook) describing the legislation. Bluebooks are largely compiled from the House and Senate committee reports. Since they are written after the legislation has been enacted, Bluebooks are not really legislative history and they do not have the authority of pre-enactment committee reports.

Judicial Opinions

B. Tax Litigation

There are three judicial forums in which a taxpayer can litigate:

1) U.S. District Court for the district in which the taxpayer resides

2) Court of Federal Claims (no juries)

3) U.S. Tax Court

In the District Court and the Court of Federal claims, the tax payer can only litigate after paying the disputed tax and suing for a refund. In Tax Court, the taxpayer can litigate without having first paid the tax. A taxpayer invokes the jurisdiction of the Tax Court by filing a petition within 90 days of the date of a notice of deficiency issued by the IRS.

Tax Court is headquartered in Washington, D.C. Tax Court judges ride circuit throughout the country, so a taxpayer does not have to travel to Washington to present her case. Most tax opinions are issued by a single judge but important issues can be submitted to a panel of all judges, sitting en banc. All Tax Court trials are bench trials (no juries). Opinions are designated as either memorandum or regular opinions. A memorandum opinion applies well-established law to the facts of a particular case, while a regular opinion involves more interesting legal issues. Both types of opinions have precedential value, although regular opinions have somewhat greater weight, and en banc opinions (identified as reviewed by the Court) have particularly strong precedential value.

The appeal from either the Tax Court or a district court is to the U.S. Court of Appeals for the circuit in which the taxpayer resides. An appeal from the Court of Federal Claims lies with the Court of Appeals for the Federal Circuit. If a taxpayer loses a case begun in Tax Court, he must pay not only the deficiency, but also interest running from the original due date of the return, at the Federal short-term rate plus three percentage points. If the tax payer wins a refund case, the government will pay the taxpayer both the amount of the overpayment and interest on the overpayment.

C. Steps in Computing Taxable Income

See HB 360

1.) Gross Income

2.) Less: deductions allowed above the line as provided by 62

3.) Yields: Adjusted Gross Income (AGI)

4.) Less: The greater of itemized deductions or the standard deduction

5.) Less: Deductions for personal and dependency exemptions

6.) Yields: Taxable income

7.) Calculate Tax

8.) Less: Any tax creditsII. Ethics

A. Standards for Tax AttorneysThere are three different rules that a tax attorney must follow when determining whether to advise a taxpayer to take a specific position on his return: (1) an ABA opinion, (2) a Treasury Regulation, and (3) a statutory provision.

1. ABA Formal Opinion 85-352CB 65, HB 649

Opinion 85-352 states that a lawyer can advise that a client take a position on his or her return as long as: (1) the lawyer has a good faith belief that the position is warranted in existing law or can be supported by a good faith argument for an extension, modification, or reversal of existing law; and (2) there is some realistic possibility of success if the matter is litigated.

The commentary to the opinion states that realistic possibility of success should not be a position having only a 5% or 10% likelihood of success if litigated but rather approximating 1/3. In determining the chance of success, the probability of an audit cannot be taken into account. However, since the commentary is not part of the actual opinion it is unclear how much weight it should be given.

This opinion makes clear the ABAs position that the attorney has a duty to the client above all else and the filing of a tax return may be the first step in a process that may result in an adversary relationship between the client and the IRS.

Summary: It is okay to take aggressive positions, even ones without substantial authority and it is okay to do so without disclosure, as long as the attorney believes that you have between a 10 and 33 percent chance of success (or greater).

2. IRS Circular 230 Best Practices and Other Standards (31 C.F.R. 10.34)

CB 69 and HB 652

Circular 230 sets out the requirements for attorneys and other agents wishing to practice before the IRS. An attorney who violates these requirements may be fined, suspended, or disbarred from practicing before the IRS.Circular 230 uses realistic possibility of success but defines it as at least a one in three (1/3) chance of succeeding on the merits. An attorney can rely on representations of fact made by his client. He cannot ignore information furnished to him or actually known by him and must make a reasonable inquiry if the information appears to be incorrect or inconsistent with other facts or factual assumptions.

A practitioner may not provide written advice to a taxpayer that: (1) is based on unreasonable factual or legal assumptions; (2) fails to take into account all relevant facts that the practitioner should know; or (3) considers the chance of audit or the chance that the issue will not be raised on audit.

If the practitioner knows that third parties will use or rely on this advice in marketing or promoting tax shelters, the IRS will apply a heightened standard of care.

3. Section 6694

a. $250 Penalty

This section imposes a $250 penalty on an income tax return preparer who prepares a return (or provides advice in connection with the preparation of a return) that takes an undisclosed position for which there was not a realistic possibility of success on the merits. Adequate disclosure of the position will avoid the penalty as long as the position is not frivolous. Similar to Circular 230, a realistic possibility of success is at least a one-in-three chance of prevailing on the merits.

This penalty is probably most significant for a preparer preparing a high-volume of low-fee tax returns. The preparer may also be concerned that a 6694 penalty will trigger disciplinary action under Circular 230.

b. $1,000 Penalty 6694(b)

If the understatement was due to willful or reckless conduct, or to an intentional disregard of rules or regulations. The regulations provide that a realistic possibility of success is at least a one in three chance of success on the merits and the chance of an audit (or the chance of getting caught) cannot be considered in making this determination.

B. Standards for Taxpayers

6662 imposes a penalty on a taxpayer who files a tax return that understates his correct tax liability by more than the greater of $5,000 or 10 percent of the correct tax liability. The penalty is 20 percent of the understatement. An understatement subject to penalty does not arise from either (1) an undisclosed return position for which the taxpayer had substantial authority, or (2) a position that lacks substantial authority, but that is adequately disclosed and for which there is a reasonable basis. Good faith reliance on professional advice is a reason for relief under 6664(c).

III. The Scope of Gross Income

A. Cash Receipts: Does Source Matter?

1. Generally, No

IRC 61 defines gross income as all income from whatever source derived. The statute gives 15 examples, but income is not limited to those examples.

Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) CB p 77

Two cases were consolidated in this case. One case involved exemplary damages for fraud and the other involved punitive damages. The issue in this case was whether money received as exemplary damages for fraud or as the punitive portion of antitrust recovery must be reported by a taxpayer under 61. The Court held that Congress applied no limitations as to the source. Not only are the compensatory damages taxable but so are punitive damages. The punitive damages are accessions to wealth.

Cesarini v. United States, 296 F. Supp. 3 (N.D. Ohio 1969) CB p 81

The taxpayers bought a piano for $15 in 1957. In 1964, the taxpayers discovered $4,000 in the piano. The taxpayers filed a return claiming the discovered as money. They later filed an amended return excluding the found money and claiming a refund. The taxpayers argued (1) the found money was not income; (2) if it was income, it was income in 1957 and therefore the statute of limitations had run; or (3) if it was income, it should be taxed at the capital gains rate. The court held that it was income in the year it was found and that the concept of income is broad enough to cover this.

Treas. Reg. 1.61-14 provides that treasure trove is income in the year when it is reduced to undisputed possession.

Baseball: CB 202 204; HB 57 - 59

What are the tax implications to a fan who catches a ball worth $1,000,000?

First, a fan who caught the ball would probably have income of $1,000,000. If he won the lottery or a prize it would be taxed. If the fan catches the ball, if he gives it to someone else (for instance McGwire), the fan is exercising control and it seems the fan would not only be responsible for income tax but for a gift tax. In IRS Press Release IR-98-56, the IRS said there would be no tax implications if fans gave back the ball (but what about not giving it back but giving it to McGwire?). One argument against taxation is that the baseball is like self-created property or imputed income and should not be taxed until it is sold.

2. Tax-Free Recovery of Capital is Allowed

61(a)(3) states that gross income includes gains derived from dealings in property. 1001(a) defines the gain on the sale of property as the excess of the amount realized on the sale over the adjusted basis of the property. 1001(b) defines a taxpayers amount realized on a sale as the cash received by the taxpayer plus the fair market value of any non-cash property received. 1012 defines a taxpayers basis in an asset as the cost of such property.

3. Statutory Exclusions (Congress Says Source Matters)

a. Gifts and Bequests

Commissioner v. Duberstein, 363 U.S. 278 (1960) CB p 87

102 excludes gift from income. The issue was what constitutes a gift. The Court held that a gift is given with detached and disinterested interest. The Court punts holding that trial courts are better at determining the mainsprings of human conduct. The Court stated that the factual findings of lower courts will generally be upheld.

Under 274(b), businesses cant deduct a gift as a business expense (only up to $25 per individual). Under 102(c), any amount given to an employee cannot be excluded from the employees income (but see Treas. Reg. 1.132-6(e)(1) which excludes non-cash low value traditional birthday or holiday gifts as a de minimus fringe).

Hypo: Husband employs wife. H gives W a birthday gift. This is excludable because it is not in the scope of employment.

b. Damages on Account of Personal Physical Injuries (CB 99-103)

(i) Generally 104(a)(2) excludes from gross income any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. The exclusion applies to: (1) non-pecuniary damages for pain and suffering or loss of enjoyment; (2) damages for medical expenses (past and future); or (3) damages for lost wages (past and future).

104(a)(2) is very important for lawyers. Their goal is to get their client within 104(a)(2). For example, you sue for $6 million. Part of this $6 million is probably threat of punitive damages. You start talking settlement. You use the settlement agreement as a way to classify all the recovery as compensatory rather than punitive.

Example: When Dennis Rodman kicked the cameraman, the attorney for the cameraman would say that it is excludable because it was for damages. The government argued that not all of that money was for pain and suffering.

(a) Non-pecuniary damagesFor example, if a violinists hand is injured and she recovers $1 million, the recovery is not taxed. There are two reasons for this rule. First, the hand is worth $1 million and this is simply a recovery of capital. Second, we dont kick a person when they are down.

There are two problems with these justifications. First, for other purposes, we assume zero basis of a body part a person cant take a deduction if they lose the arm through their own fault. We also have a problem of inequality where one person collects and the other doesnt.

(b) Medical Expenses

The policy justification for exclusion of medical expenses is that they would be deductible anyway under IRC 213. In practice, however, 104(a)(2) provides better results than 213 because the medical expense deduction ( 213) is only allowed for medical expenses in excess of 7.5 percent of the taxpayers adjusted gross income and is not available if the taxpayer takes the standard deduction.

(c) Lost wages

This exclusion is hard to justify because if the person had not been injured and had earned the wages, the wages would not have been excludable. One argument is the difficulty in separating the lost wages damages from other damages. Another argument is that the exclusion is a tax subsidy for the tort plaintiffs contingent attorneys fees.(ii) The Physical Injury RequirementPrior to 1996, the exclusion applied to damages on account of personal injuries whether physical or not. Courts had great difficulty deciding which nonphysical injuries qualified as personal injuries, damages for which were excludable. In 1996, 104(a)(2) was amended and the word physical was added. The amendment reduced confusion as to what injuries the section applied, but it is less fair. There is no policy reason why recoveries for physical injuries should be excluded but recoveries for nonphysical injuries should not be excluded.(iii) Emotional Distress

Under 104(a), emotional distress shall not be treated as a physical injury or physical sickness. However, this does not apply to amounts not over the amount paid for medical care which is attributed to the emotional distress. According to the committee report, it seems that damages for injuries which lead to emotional distress are excludable but damages for emotional distress which leads to injuries is not excludable.

(iv) Loss of Consortium and Wrongful Death

The committee reports specifically say that loss of consortium and wrongful death are specifically excludable.

(v) Structured Settlements

Under 104(a)(2), periodic payments are excludable. If a person receives a lump sum and subsequently invests the lump sum, the lump sum is excludable but gains on the investment are not excludable. However, if a person negotiates a structured settlement, the payor can invest the money and the structured payments are not taxable.

Why wouldnt people take structured settlement?

1) Opportunity cost you think you can do better

2) In real life, companies want to split the tax benefits.

c. Life Insurance 101(a) provides that gross income does not include amounts received [] under a life insurance contract, if such amounts are paid by reason of the death of the insured.

(i) Types of Life Insurance

There are essentially two types of life insurance policies: (1) term life insurance; or (2) whole life insurance.

Term Life Insurance: I pay each year an amount which represents the chance of me dying. I am betting that I am going to die; the insurance company is betting that I am going to live. The insurance policy only covers me dying within a specified term. Each year, the insurance policy becomes more expensive.

Whole Life Insurance: This is a combination of term and investment. There is a level payment. Each year, I pay the same amount.

Universal Life: This type has become very popular within the last generation. There are various forms, but they have in common the fact that substantial investment aspects are combined with a core life insurance element. In the early forms of this type, the investment dominated the life insurance aspect. Congress significantly cut back when it added 7703 to the code. The purpose of which was to make the premiums paid related to the actuarial risk. This limits the ability to create large investment accounts within the umbrella of a life insurance contract.

(ii) Exclusion for Life Insurance Proceeds

101 of the Code provides that amounts received as the proceeds of life insurance are not includible in gross income.

The advantages of exclusion of life insurance death benefits have recently been extended to cover situations in which a dying policyholder receives a pre-death insurance benefit. Many life insurance policies permit payment of all or a part of the death benefit to the insured himself, prior to death, if he is terminally ill. Viatical settlement providers have arisen to purchase or take assignments of an insureds interest in a life insurance policy if he is terminally ill. Under 101(g), allows such payments either from the insurance company or from sale or assignment of rights to a viatical settlement company to qualify for the exclusion granted by 101(a) for life insurance proceeds.

Payments made to chronically ill patients may also be excluded as death benefits if the payments are used to defray certain long-term care expenses a limitation that does not apply to the terminally ill.

d. Other Source-Based Exclusions for Cash Receipts

Other important exclusions include: (1) 103 exclusion for interest on municipal bonds; (2) 121 exclusion for gain on the sale of a personal residence; (3) 86 exclusion for social security benefits; (4) general welfare exclusion there is no statutory basis but is has long been recognized by the IRS; (5) 139 qualified disaster relief payments; (6) there are numerous other exclusion provisions.

B. Is it taxable if it isnt cash?

1. Generally, Yes, as far as 61 is concerned

Generally, even if it isnt cash, it is still taxable. The problem is valuation. For example, if you received 100 snickers bars, how would you be taxed? The IRS might try to value you them at 60 cents each since that is what they are sold for. You could attempt to argue that a reasonable person would not buy 100 snickers bars at 60 cents each, rather they should be valued at the bulk price.

Rooney v. Commissioner, 88 T.C. 523 (1987) CB 110

Four of clients of an accounting firm became delinquent in paying for services. The firm allowed their partners to receive goods and services from the clients for free. In return, they reduced the clients debt to the partnership by an amount equal to the price normally charged for such goods and services by the client to its retail customers. Later, the partners became dissatisfied with the cross-accounting arrangement with the clients. They determined that some of the goods received were overpriced and that some of the services were not satisfactorily performed and that therefore the value to them of the goods and services was less than the normal retail prices charged by such clients. The partners discounted the retail prices of the goods and services received by them from the four clients and reduced the partnerships gross receipts account by the amount of the discount. The issue before the court was whether the firm could discount the retail prices of goods and services received by considering the partners subjective determination of value.

The court held that the fair market value of the goods and services received by the firm was the prices charged by the firms clients and not the subjective valuation.

Note that there is still room for argument with objective FMV. For example, one person might use the price charged by K-Mart while the other uses Saks Fifth Ave.

Revenue Ruling 57-374

An individual who refuses to accept an all-expense paid vacation trip he won as a prize in a contest does not have to include the FMV of the trip in his income.

The CB points out that the person has constructive receipt and therefore should be taxed. If a check is handed out on December 31, Year 1 but I dont pick it up until January 2, Year 2, it is still included in taxes for year 1 because I had constructive receipt. The CB also argues that there is no statutory basis for this ruling.

Arguments for allowing this ruling: we dont tax people for raises they dont take, and we arent taxed for working at the DOJ rather than a law firm. We have the freedom to have less money.

2. Two Great Non-Statutory Exclusions of Non-Cash Economic Benefits

a. Imputed Income p 115

If I paint my own house, I am not taxed on the FMV of hiring a professional painter to paint the house. However, if services are paid for in exchange for other services, the FMV of such services must be included in income. See Rooney supra, see also Treas. Reg. 1.61-2(d)(1). Reasons for not taxing imputed income: privacy and non-erosion of tax base (people wont do it just to avoid taxes like they would if we excluded bartered income).

The problems with not taxing imputed income are evidenced by the following example (see CB 117-118):Couple 1: H makes $80,000 and W makes $0 because she is a stay out home mom.

Couple 2: H makes $40,000 and W makes $40,000. Couple 2 has to pay for day care, house cleaning, and maybe they eat out more, e.g. $16,000.

The problems with imputed income are (1) equality and (2) efficiency. There is a problem with equality there is no horizontal equity. The same income ends in different results. Couple 1 has imputed income of $96,000 which is subsidized by the government. Furthermore, taxation might lead to efficiency problems. For example, see Carla and Chuck (p 118). Assume Carla takes a job for $30,000, pays tax of $12,000, and $20,000 for child services. Society wants her to be a public safety officer because it values that higher than her staying home with her children ($30,000 vs. $20,000) but it isnt worth it to her.The IRS has ruled that services means in the context of business. For example, (CB 119) if Karen and Sandra are good friends such that when Karen goes on vacation Sandra feeds Karens cats and waters Karens lawn and Karen does the same when Sandra goes on vacation, this would not be income because neither is in the business of watching cats and watering lawns.

Helping out a friend only applies to services, it does not apply to property. For example (CB 122 Problem 9) if two professors agree to a temporary house swap, there is income to both professors.

b. Unrealized Appreciation p 122

Unrealized appreciation is not included in gross income. However, upon sale, 1001, you are taxed on the gain. The usual policy explanation for the exclusion is that taxation of unrealized appreciation would involve tremendous problems of valuation and liquidity. This is not a permanent exclusion but rather a deferral. Taxation is deferred until sale (unless the person dies in which case 1014 applies).

Anti-flip rule: If I sell securities to realize a loss, I cant realize the loss if I repurchase the securities within 30 days.

In Eisner v. Macomber, 252 U.S. 189 (1920), the Supreme Court held that the exclusion of unrealized appreciation from gross income was required by the Constitution. Although the case hasnt been formally overruled, later Supreme Court opinions appear to have demoted it from constitutional status. Under the current view, Congress has the power to tax unrealized appreciation to the extent it sees fit. For example, 475 requires securities deals to mark to market their securities each year.

3. Statutory Exclusions Based on the Non-Cash Nature of the Benefit

In general, non-cash economic benefits are includable in gross income in the absence of an explicit exclusion provision.

a. Employer-Provided Health Insurance

106(a) excludes from the gross income the value of employer-provided health insurance coverage. 105(b), excludes from gross income the value of benefits received under employer-provided health insurance, to the extent the benefits constitute reimbursement of medical expenses. If an employee pays through payroll deduction, the amount paid is excluded from gross income. 125 provides that health insurance coverage may be offered under a cafeteria plan. Under the cafeteria plan rules of 125, a taxpayer who is offered a choice between cash and health insurance coverage, and who chooses insurance, will not be taxed under the doctrine of constructive receipt.

The regulations state that the exclusion only applies to health insurance for the employee, his spouse, or his dependents as defined in 152. Treas. Reg. 1.106-1. If an employer provides health insurance coverage for unmarried partners of its employees, the value of the partner coverage cannot be excluded unless the partner qualifies as a dependent.

Taxpayers who do not have health insurance through their employers, 213 allows them to claim their medical expenses including health insurance premiums not excluded under 106 as itemized deductions. However, under 213(a), medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income. This is an example of how the code prefers employer provided benefits to similar items purchased by a taxpayer with his own money.

b. Group-Term Life Insurance

79 allows employees to exclude the value of group-term life insurance provided by their employers, for up to $50,000 of insurance. Larger amounts of insurance can be provided, but to the extent that the policy exceeds the $50,000 face amount permitted to be received tax free, 79 provides that the employee has additional wage income in the amount of the premium properly allocable to the excess coverage.

c. Scholarships and Other Tax Benefits for Higher Education Expenses CB 130

117(a) excludes from gross income any amount received as a qualified scholarship by an individual who is a candidate for a degree at a college or university. The exclusion applies both to cash scholarships and to scholarships received in-kind (in the form of free or reduced tuition). The exclusion is limited to the amount of the students tuition and fees, and the cost of course-related books, supplies, and equipment. 117(c) provides that the exclusion does not apply to any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship. If a grant is in the form of a scholarship but is really compensation for services, it will be treated as income.

An exclusion is allowed for a qualified tuition reduction, which is defined as a reduction in tuition provided to an employee of an educational institution for the education of the individual or his spouse or dependents (also available for tuition reduction plans at other educational institutions, e.g. through an exchange program). 117(d)(3).

Argument for not taxing: Education is very important and we want to encourage it.

Argument for taxing: If you work, make the money, and pay, you are taxed. If you are lucky enough to get a scholarship, you are not taxed.

117 is thought to operate bizarrely in equity. The Hope Credit and Lifetime Learning credit were intended to make it more equitable.

Rev. Proc 76-47 CB 132-135This revenue procedure gives guidelines for determining whether a grant made by a private foundation under an employer-related grant program to an employee or child of an employee is a scholarship under 117(a).

In addition to 117, Congress has enacted the Hope Scholarship Credit ( 25A(b)) and the Lifetime Learning Credit ( 25A(c)). The credits are available for qualified tuition (defined in 25A(f)) and related expenses incurred by the taxpayer, his spouse, or his dependents. The credits are not refundable (no payment if credit is larger than the taxpayers liability). Credits mean a dollar for dollar reduction (but sometimes the code puts a percentage limit). The Hope Credit and the Lifetime Learning Credit are phased out based on the taxpayers modified adjusted gross income. For married couple filing jointly, the credits phase out from $87,000 to $107,000. For a single filer, the credits phase out from $43,000 to $53,000.

An argument in favor of a government subsidy for education is that it is investment in human capital which we want to encourage. An argument against is that education is a personal consumption choice that the taxpayer made.

Hope Scholarship Credit CB 136; HB 644-646; P 247-253The Hope Scholarship credit provides a maximum credit to the person paying the expenses of $1,500 per student for each of the students first two years of postsecondary education. The credit allows a 100 percent credit per eligible student for the first $1,000 of tuition expenses (room, board, and books are not covered). Then it allows a 50 percent credit for the second $1,000 of tuition paid. The student must be enrolled at least on a half time basis. Since it is available on a per student basis, if there are three qualifying students, the Hope Scholarship Credit may be claimed for all three.

Lifetime Learning Credit

The is a credit of 20% of qualified tuition expenses paid by the taxpayer for any year the Hope Credit is not claimed. The credit is taken by taking 20% of the first $5,000 of tuition paid by the taxpayer in years before 2003 and the first $10,000 after 2003. The credit is calculated per taxpayer and the amount does not change based on the number of students in the taxpayers family. The Lifetime Learning Credit can be claimed for an unlimited number of years and can be used for both undergraduate and graduate tuition and fees.

222 Deduction for Qualified Tuition 222 allows you to deduct rather than claiming a credit whether this is better than hope or lifetime depends on your marginal rates. Taxpayers can deduct, above the line, a portion of their qualified tuition (which means they can take this in addition to the standard deduction). For years before 2006, taxpayers with AGI that does not exceed $65,000 ($130,000 for joint returns) may deduct up to $2,000. Qualified tuition is the same definition as for the Hope Credit and the Lifetime Learning Credit. You cannot claim both the deduction and the Hope or Lifetime Credit.

d. Fringe Benefits ( 132): CB 205-208; HB 59-65

An employer may provide fringe benefits to an employee as compensation for working for the employer. Under the broad definition of 61, the presumption is that such benefits are income. 132 provides an exclusion from gross income certain fringe benefits. As to (1) and (2) below, they are only available to highly compensated employees only if offered to other employees on a nondiscriminatory basis (nondiscriminatory means compensation in this context). 132(h)(1) provides that retired and disabled employees and surviving spouses are treated as employees for purposes of subsections (a)(1) and (2). In addition, spouses and dependent children are treated as employees under 132(h)(2). Parents of an airline employee are treated as an employee and can get free standby tickets under 132(h)(3).

(1) A no-additional-cost service: 132(b)

This is a service provided by an employer to an employee if: 1) the service is offered for sale to customers in the ordinary course of the employers line of business in which the employee is performing services; and 2) the employer incurs no substantial cost (including foregone revenue) in providing the service to the employee (determined without considering any amount paid by the employee for the service). Also, employers can have reciprocal agreements where the employers provide services to each others employees if the reciprocal agreement is in a written agreement and no employer incurs any substantial additional cost. See 132(i).

(2) A qualified employee discount: 132(c)

With respect to a product, the discount cannot exceed the difference between the sales price of the product and the cost to the employer. With respect to a service, the discount cannot exceed 20% of the price at which the services are offered by the employer to customers. If the discount is greater than these limits, only the amount of the discount which does not exceed these limits is excludible and the balance is includible in the income of the employee. The property cannot be real property or property held for investment. In addition, the discount must be on property or services offered in the ordinary course of the line of business of the employer in which the employee is performing services.

(3) A working condition fringe: 132(d)

This is any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction to the employee under 162 (ordinary and necessary business expense) or 167 (depreciation).

(4) A de minimis fringe: 132(e)

This is any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employers employees) so small as to make accounting for it unreasonable or administratively impracticable.

An eating facility operated by the employer qualifies if (a) the facility is located near or on the business premises of the employer and (b) the revenue derived from the facility normally equals or exceeds the direct operating costs of the facility. An employee entitled under 119 to exclude the value of a meal (the meal is furnished for the convenience of the employer and furnished on the business premises) is treated as having paid an amount equal to the operating costs of the facility attributable to the meal.

(5) A qualified transportation fringe: 132(f)

This is qualified parking, transit passes, or transportation in a commuter highway vehicle (vehicle that seats at least 7 people) provided by the employer to the employee. A qualified transportation fringe may not exceed $105 per month for the aggregate of transportation passes and amounts spent on commuter highway vehicles, and $200 per month for qualified parking.

e. Restricted Property and Stock Options: CB 222-230

If a taxpayer performs services and property is transferred in connection with performance of those services, then the taxpayer is taxed under 83(a) on the fair market value of the property at the time of transfer (reduced by any amount paid by the taxpayer for the property). However, transferred property is not taxable if the taxpayers rights are not substantially vested. A taxpayers rights are not substantially vested if they are subject to a substantial risk of forfeiture and are not transferable. If substantially nonvested property later becomes vested, the tax under 83(a) is imposed at the time of vesting. The amount included in gross income depends on the value of the property at the time of vesting. The employers business expense deduction under 162 is taken when the employee includes under 83. The employer is allowed a deduction equal in amount to the employees inclusion and in the same year as the employees inclusion.

Section 83(c)(1) defines substantial risk of forfeiture and 83(c)(2) defines transferability. Section 83(a) states that the property is taxable to the person who performed the services if the property is transferred in connection with those services. This means that if taxpayer does work for his employer and the employer gives property to the sister of the taxpayer, the taxpayer is responsible for paying the tax. The same result would be reached through Lucas v. Earl CB 733.Under 83(b), a person can elect to include in gross income in the year in which the property is transferred. However, if this election is made and the property is subsequently forfeited, the taxpayer cant take a deduction. The taxpayer should always take the 83(b) election when the election will trigger no current income tax liability because the taxpayer purchased the property for its fair market value. See Alves v. Commissioner CB 225.

Alves v. Commissioner p 225

The taxpayer, as part of his employment agreement, purchased 40,000 shares of stock at ten cents per share. Both the IRS and the taxpayer stipulated that the shares had a FMV of ten cents per share when the taxpayer purchased the share. In addition both parties agreed that the taxpayer did not make a 83(b) election. The taxpayer argued that 83(a) does not apply to purchases for FMV. He argued that in connection with meant that the employee is receiving compensation for his performance of services. The court held that the statute applies to all property transferred in connection with the performance of services. It is not limited to compensation. The taxpayer also argued that this is a tax trap of taxpayers who are not well informed. The tax court says too bad Section 83(b) is but one example of a provision requiring taxpayers to act or suffer less attractive tax consequences.

Section 83(e)(3) states that 83 does not apply to transfer of an option without readily ascertainable FMV and most options do not have a readily ascertainable FMV. However, when the taxpayer exercises the option she will be taxed under 83(a). Different rules apply to incentive stock options.

4. De Facto Administrative Exclusion Frequent Flier Miles: CB 213-221A Technical Advice Memorandum (TAM) is written to an IRS agent in the field instructing the agent how to handle a situation. However a TAM cannot be cited as precedent. A TAM is basically an unpublished ruling. Published rulings may be cited as precedent.

In TAM 9547001 CB 213, the taxpayer was allowing its employees to keep frequent flier miles earned on trips paid for by the company. The TAM argues that the frequent flier miles are a rebate against the price and therefore allowing the employees to keep the miles is a form of compensation.

In an announcement, 2002-10 I.R.B. 621 CB 220, the IRS backed down saying that the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayers business or official travel did not give rise to tax liability.

Some reasons why this might be the right answer include: valuation problems (but is this any different than other valuation problems we face); administration problems (it might be too expensive to keep track); de minimus fringe (it doesnt fall under 132 but it is de minimus fringe in general).

C. Income Inclusions as Mistake-Correcting Devices

1. The Annual Tax Accounting Period

The taxable year is arbitrarily Jan. 1 to Dec. 31. In Burnet v. Sanford & Brooks Co., the Court held that the government requires revenue ascertainable, and payable to [it], at regular intervals. This causes inequities. For example, if a day trader makes $2 million on December 30 and on Jan. 3, he loses $2 million, although he has no net gain or loss he still owes the government tax on the $2 million.

For businesses (including sole proprietorships) there is some relief through the Net Operating Loss (NOL) provision of 172, allows a taxpayer with a NOL in one tax year to use the NOL to offset positive income in other years. An NOL may be used to offset net income in the two years preceding the loss year and in the 20 years following the loss year. An NOL is carried first to the earliest permissible year, to the extent it exceeds the income in the earliest year, the excess is carried to the following year.

Correction of Income Tax Mistakes:There are two types of mistakes:1) You lacked correct information or advice when you filed the tax return. To correct this, you file an amended return.

2) Things turned out differently. Based on the world at the time you filed, you filed correctly. Then the world changed and your taxes become incorrect. For example, on December 31, you receive a check from your law firm for $20,000 and a note which says it is a bonus. You include the $20,000 as income. In January, the firm sends out notice that a mistake was made and the check should have been $2,000. You have an $18,000 loss for the year in which you learned about the mistake. See CB 143 n.4. Even if you discovered the mistake before April 15, you still have to declare $20,000 of income for year 1 and an $18,000 loss for year 2.

2. Loans and Cancellation of Indebtedness

a. General Rule

A taxpayer does not have to include money borrowed money in income, but the taxpayer does not get a deduction for repaying the loan. The usual justification is that the taxpayer is no wealthier than he was before the loan, he received the loan but he also created a liability to repay the loan. Similarly, the lender does not have a deduction on making the loan and does not have income on repayment. However, if the loan is discharged, their might be income. 61(a)(12) assumes that discharge of indebtedness is income. 108 provides exceptions which remove discharge of indebtedness from income.

In Old Colony Trust v. Commissioner HB 52, a company paid there president a salary and in addition agreed to pay the presidents income taxes. The Court held the payment of taxes by the company was income to the president, because the presidents wealth was increased by the payment (he didnt have to pay).

In Clark v. Commissioner HB 123, tax counsel gave incorrect advice to the taxpayer which resulted in the taxpayer paying $19,000 too much in taxes. The tax counsel reimbursed the taxpayer. The IRS asserted the reimbursement was income. The taxpayer argued that it was merely a return of capital. The court held it was not income. The IRS has taken the position that Clark applies when taxpayers pay more than their minimum proper federal income tax liabilities and are reimbursed by a third party for those amounts. The IRS has distinguished Clark from other cases where the payment was not due to an error made on the return itself but on an omission to provide advice that would have reduced federal income tax liability. Mistakes on the return are a return of capital but mistakes in planning are not.

In general, Old Colony can be distinguished from Clark because in Old Colony, the company paying the taxpayers income taxes was compensatory whereas in Clark, the reimbursement for taxes was a return of capital.In United States v. Kirby Lumber Co. CB 141; HB 125

Kirby Lumber Co. issued $12 million of bonds, later that year the company purchased back approximately $1 million of these bonds for $862,000. Thus, the company saved $138,000. The issue was whether this $138,000 was includable in Kirbys income. The Court held that Kirby had an accession to income.

In order to have debt cancellation, there has to be a valid debt. Zarin v. Commissioner CB The taxpayer ran up $3,435,000 in gambling debts at Resorts Hotel. Resorts filed suit against the taxpayer but eventually settled for $500,000. The IRS argued that the $3,435,000 was a loan and the settlement for $500,000 was a cancellation of $2,935,000 of indebtedness. The court held the debt owed to Resorts was unenforceable as a matter of New Jersey law because Resort violated Casino Commission rules. Thus the debt was not one for which the taxpayer was liable and the cancellation was not income. One possible argument is that if it wasnt a loan, why wasnt he taxed on the money when he received it? The court seemed to say that it wasnt real money but rather like monopoly money.

b. Defining Debt Cancellation Income

Bradford v. Commissioner CB 234

H had accumulated about $300,000 in debt. To make his finances look better, W agreed to assume $205,000 by giving a note in her name to the bank in exchange for Hs note to the bank. The bank split the notes into a secured note for $105,000 and an unsecured note for $100,000. Later, the bank, on its books, wrote $50,000 off the unsecured note. The bank offered to sell the $100,000 note for $50,000. Hs half-brother purchased the note for $50,000. The tax court held that the $50,000 writeoff was a discharge of Ws indebtedness. The Court of Appeals reversed. The court held that W never received any income from the transaction. The court compared it to a reduction in price. The person that actually received the discharge of indebtedness was H and he was not before the court.

c. Insolvent or Bankrupt DebtorIf a debtor is insolvent and receives a discharge from indebtedness under the Bankruptcy Code, the amount of income from discharge of indebtedness is excluded from the debtors income. See IRC 108.

d. Debt Relief Associated with the Disposition of Property CB 154

Where the property is purchased for a down payment plus debt obligations of the purchaser, the usual rule is that the basis is the full amount of the purchase price even though some of it is not yet paid. The mortgage plus any other cash or property is included when calculating the amount realized.

In Crane v. Commissioner HB 178 (discussed in Tufts CB 157), taxpayer had property with a FMV of $262,000 and a mortgage of $262,000. The taxpayer took depreciation deductions of $25,000. The taxpayer then sold the property for $2,500 cash and assumption of the mortgage. The court held that a nonrecourse mortgage is included in calculating the taxpayers basis (e.g. cash paid for the property plus the amount of the mortgage).

Mortgaging property subsequent to its acquisition doe not increase basis. Woodsam Associates, Inc. v. Commissioner HB 185. The mortgaging of an already-held property is not a realizing event.

For example: Figure HB 185

In year 1, Janice bought Blackacre for $500,000 cash. In year 4, Blackacre is worth $1 million. Janice takes out a nonrecourse mortgage of $750,000. She claims that the $250,000 was income but the statute of limitations has run. In year 10, she allows the bank to foreclose on the property. The court held the mortgage in year 4 was not a realizing event. Therefore, the basis was not increased. On the forclosure, Janices basis was $500,000 (the amount she purchased it for) and the amount received was $750,000 (the amount which was cancelled in foreclosure) and therefore she had a gain of $250,000.

In footnote 37 of Crane, the court declined to consider what would happen if at the time of the sale of the property, the property had a fair market value of less than the amount of the mortgage (this can only happen if the property has declined in value after the mortgage has been put on it). This was answered in Tufts.

Commissioner v. Tufts CB 157; HB 192

The taxpayers obtained a nonrecourse loan in the amount of $1.85 million to build a building. After the building was built, the taxpayers took depreciation which left an adjusted basis of $1.4 million. The FMV of the property dropped to $1.4 million. The taxpayers sold the property to a third party who agreed assumed the mortgage as the full payment. The taxpayers argued that the amount realized was $1.4 million so there was no gain or loss. The IRS argued that the gain was the amount realized was $1.85 million minus the adjusted basis of $1.4 million resulting in a gain of $450,000. The court held the full amount of the nonrecourse mortgage is the amount realized to the taxpayer on the sale of the property even though it is greater than the FMV of the property. It is easy to see this is the correct result. If the result came out the other way, people could take out an excessively high mortgage on a property and depreciate down to the FMV of the property and then sell.

The $450,000 gain in Tufts is often called phantom gain or Tufts gain.

In OConnors concurrence to Tufts, OConnor would bifurcate the analysis. The property would be treated as being sold at FMV. Therefore, the gain realized would be the FMV adjusted basis. The discharge of indebtedness would be the amount of the mortgage FMV. It only matters which formula you use when the debtor is insolvent.If the loan is recourse, see Rev. Rul. 90-16 CB 166.

X was insolvent ( 108(d)(3)) and defaulted on a recourse loan. X negotiated with the bank to transfer the property to the bank and the bank released X from liability. The FMV of the property was 10,000, Xs adjusted basis was 8,000, and the amount due on the debt was 12,000. The ruling held that 2,000 was gain (10,000 FMV 8,000 adjusted basis) and 2,000 was discharge of indebtedness which would be taxable, except under 108(a)(1)(B) the full amount of Xs discharge of indebtedness is excluded because that amount does not exceed the amount by which X was insolvent.

Therefore, if the debtor is insolvent, OConnors approach is better for the debtor because the amount above the FMV is discharge of indebtedness which is not taxable under 108(a)(1)(B). OConnors approach is only used for recourse loans. Under Tufts, the amount realized is not the FMV but rather the amount of the loan and there is no discharge of indebtedness.

3. The Tax Benefit Rule

The tax benefit rule applies where a person takes a deduction in one year and it later becomes apparent in a later year the person should not have taken the deduction, if the deduction generated a tax benefit.

In Hillsboro National Bank v. Commissioner CB 171, the Court held that the purpose of the tax benefit rule is to create transactional parity which corrects a reported transaction which was reported on the basis of assumptions that an event in a subsequent year proves to be erroneous. In the case, the Court gives an example where a taxpayer signs a 30 day lease on December 15. On January 10, a fire burns down the building. The tax benefit rule does not apply because the event is not inconsistent with the deduction. This is still a business expense. However, if the taxpayer instead of using it for his business used it to house his family, this would be inconsistent with the business expense deduction and the tax benefit rule would apply.

Another example: Taxpayer lends $1,000 to D in year 1. Later that year, it appears D will never pay the debt, so the taxpayer takes a deduction of $1,000. In year 2, D unexpectedly pays back the $1,000. The taxpayer argues that the $1,000 is not income because it is just repayment of a loan (recovery of capital). This argument would give a phantom deduction (an extra $1,000). Under the tax benefit rule, $1,000 is reported as income for year 2.

In Rosen v. Commissioner p 176, the taxpayers donated property to a city. They claimed a charitable deduction of $51,250. The next year, the city decided it could not use the property and returned the property to the taxpayers. The taxpayers then donated the property to a hospital taking a charitable deduction of $48,000. The hospital returned the property the next year. The court held that since the taxpayers took a charitable deduction when they transferred the property, the tax benefit rule required them to take the property as income when it was returned to them.

Once you determine that the taxpayers have to include the property as income, the question then becomes how much income?

Tax commentators would say $51,250 because the tax benefit rule is a tax correcting device.

The IRS conceded and the court held that $48,000 should be included in income because that was the value of the property they were receiving back.

If the property increased to $80,000 before it was given back, tax commentators would still say $51,250 while the IRS would say $80,000.

IRC 111 describes the treatment of deductions and credits if recovery is made in later years.

IRC 1341 is the opposite of the tax benefit rule and applies where a person receives income under a claim of right but is later required to repay the money. For an example see p 175 n.6.

IV. Property Transactions

When property is sold or otherwise disposed of, there are several steps that must be followed to determine the taxable gain. First, there must be realization, generally a sale or other disposition of the property for consideration. Next, compute the gain or loss realized, which is done by subtracting the amount realized from the adjusted basis of the property. The next step is determining whether the gain or loss will be recognized. If it is recognized, it will have significance for the taxpayers tax return. If it is not recognized, the gain or loss will be deferred until some later year. Once it is ascertained that the gain or loss will be recognized, the character of the gain must be determined whether capital or ordinary.

A. The Realization Doctrine

1. Eisner v. MacomberIncome from property must be realized before it can be taxed. The reasons for this include: valuing appreciation (although note that the price of marketable securities is easy to determine and real estate could be appraised) or taxpayer lacks the money to pay for the tax (in the case of marketable securities, the taxpayer could sell off some to pay the tax or if it is real estate tax payer could borrow against the property).

Before the appreciation in value of property can be taxed, there must be a realizing event. The property must be disposed of, usually sold or exchanged for money or other property.

Eisner v. Macomber CB 251; HB 154

Taxpayer owned 2,200 shares of Standard Oil. The taxpayer received 1,100 shares through a stock dividend. For each new share issued, the company transferred $100 (par value) from earned surplus to capital account. The issue was whether the stock dividend was taxable to the taxpayer where the statute specifically says stock dividends. The taxpayer argued that the statute violated the Constitution which required direct taxes to be apportioned according to the population and that it was not income under the Sixteenth Amendment. The court held the stock dividend did not constitute a realizing event, as required by the Constitution. Hence the statute was unconstitutional. To have income, the gain must not accrue to capital, but it must be severed from the capital for the taxpayers separate use.

Holmes dissented, saying that income included the stock dividend; therefore, the stock dividend should be taxed. Brandeis argued that if the company had made a cash dividend at the same time it offered stock and the taxpayer used the dividend to buy the stock, the taxpayer would have been taxed on the dividend. Therefore, the taxpayer should be taxed on the stock dividend.

2. Unrealized Appreciation, Stock Dividends vs. Cash Dividends

One argument that could have been made is that by distributing a stock dividend, the taxpayer in Macomber was not any wealthier (this was just cutting the same pizza into more slices). However, the same could be said for a cash dividend. In the statute, Congress treated stock dividends the same as cash dividends. To conclude the stock dividends were not taxable, the court found that the statute was unconstitutional (dealt with in the next section). The result of Macomber seems intuitively correct. Problems of valuation and liquidity justify deferring tax of the appreciation of property in the first place, these problems dont disappear when the owning of stock creates a stock dividend. The shares received in the stock dividend have the same problems with valuation and liquidity. A cash dividend does not have these problems and can easily be taxed.

3. The Constitutional IssueThat statute in question in Macomber clearly required taxation of stock dividends. The court uses the following reasoning to find the statute unconstitutional:

1) Unless the Sixteenth Amendment applies, a tax on stock dividends is an unconstitutional unapportioned direct tax on personal property.

2) The Sixteenth Amendment allows an unapportioned tax on income.

3) Unrealized appreciation is not income.

4) Stock dividends are a form of unrealized appreciation.

5) Therefore, taxing stock dividends without apportionment is unconstitutional.

The court reasons that unless a gain is clearly separated from the taxpayers original invested capital as it is in the case of a cash dividend the gain is not income and cannot be taxed by Congress without apportionment.

Later cases have demoted Macomber from Constitutional status to administrative simplification (valuation and liquidity problems in determining tax on stock dividend).

B. Manipulation of the Realization RulesSection 1001(a) states that a taxpayer realizes gain or loss on the sale or other disposition of property. This invites two types of taxpayer manipulation: (1) taxpayer wants to dispose of appreciated property through the economic equivalent of a sale without triggering 1001(a); or (2) a taxpayer owns depreciated property that he wants to retain, technically selling the property while retaining the economic equivalent of ownership.

1. The Substance of a Sale without Realization of Gain

An example of a technique used by taxpayers to sell without realizing gain was the short sale against the box. Congress enacted 1259, which requires a taxpayer to recognize gain on the constructive sale of any appreciated position in stock.

An example of a short sale against the box:

X has 100,000 shares of ABC, Inc., with FMV of $100 million and a basis of $10 million. X borrows 100,000 shares of ABC from Broker. Xs basis in the borrowed shares is $100 million. X sells the borrowed shares for $100 million and pays no tax because Xs basis is $100 million. X then gives the broker the 100,000 shares which have a basis of $10 million (plus a fee for the brokers work). X has sold her shares in ABC without being taxed.

2. The Substance of Continued Ownership with Realization of LossReg. 1.1001-1(a) states that an exchange of an asset for another asset is a realization event as long as the exchanged assets differ materially in kind or extent. Congress enacted 1091 to prevent a taxpayer from selling stock and turning around and buying it again (wash sales). Section 267(a)(1) disallows a loss deduction on a sale or exchange between certain related parties.

3. Cherry Picking 1211 Capital Loss Limitations

Section 1211 allows an individual to deduct capital losses only against capital gains and $3,000 of non-capital gain. Under 1212, capital losses can be carried forward to be used against capital gains in later years. This provision prevents taxpayers from cherry-picking, selling the stocks which have losses to take a deduction against income while not realizing gains.

C. Nonrecognition: CB 269

1. The concept of nonrecognition

There are several situations in which a taxpayer has realized a gain or loss, but the transaction will not be recognized for tax purposes (at least not at that time). The rationale is the taxpayer has maintained a substantially continuous investment, only slightly altered in form. This continuity of investment underlies congressional willingness to defer tax recognition. Nonrecognition transactions include: (1) 1031 (like kind exchanges); (2) 1033 (involuntary conversions); and (3) 121 (sale of a personal residence unlike the other two, this is not a deferral of taxation but rather a permanent exclusion).

a. Electivity

These provisions apply to both gain and loss situations; however, taxpayers can usually arrange the transactions so as to avoid applicability of nonrecognition provisions when those provisions would work to their disadvantage. However, sometimes the IRS will assert that the nonrecognition applies to defer a loss.

b. Role of Basis

Nonrecognition provisions are designed to defer recognition of gain, not to forgive taxation of the gain forever. Therefore, the general idea is to maintain a historical basis in one or more of the new assets.

2. Like-Kind Exchanges: CB 272; HB 220

If a taxpayer who holds property used in business or for investment exchanges that property for property of like kind, no gain or loss will be recognized to the taxpayer on the transaction. IRC 1031. Section 1031 only applies to property used in business or held for investment. This leaves out property held for personal use, such as ones personal residence or automobile. Section 1031(a)(2) also precludes application to several categories of property including: stocks, bonds, and notes; partnership interests; and inventory property. It can be argued that the policy reason behind this is that there is no sufficient change in investment to recognize gain. Property which is held primarily for sale is not available for 1031 treatment. If property given up and received is held for investment by the taxpayer, the transaction will count as a like-kind exchange for the taxpayer, even if the other party does not hold the property for business or investment.

a. What is an exchange?

Section 1031 requires an exchange of property; a sale will not qualify. If a taxpayer receives both like-kind property and a small amount of money for his property, he will still be regarded as having engaged in an exchange of his property. However, if money forms a substantial part of the consideration, then it may not be an exchange and instead a sale.

b. What is Like-Kind?

The regulations say that the concept of like-kind refers to the nature and character of the property, and not it its grade or quality. Some examples are in Treas. Reg. 1.1031(a)-1(c). The regulations suggest a city property could be traded for a ranch, which suggest that the nature and character of real property which can be exchanged is broad. The regulations suggest that a exchange of real property owned in fee for a lease of real property with 30 years or more to run is an exchange of like kind. Tangible personal property has to be in the same asset class to be like-kind. See Treas. Reg. 1.1031(a)-2.

c. Calculating Basis in the new property

First, it is important to remember that giving boot does not trigger recognition of gain. Receiving boot does. The easy way to calculate basis: the basis of the nonrecognition property received will be equal to the FMV of the nonrecognition property received less any unrecognized gain on the property exchanged (unrecognized gain is equal to unrecognized gain before the transaction minus recognized gain during the transaction).

d. Three-Cornered Exchanges

In Rev. Ruling 77-297, the IRS approved three-cornered exchanges. B wants to buy As property. A wants to preserve gain. A designates property which B purchases and then A and B exchange properties. For A, the transaction qualifies for 1031. 1031(a)(3) sets some time limitations for three-cornered exchanges.

3. Involuntary Conversions ( 1033): CB 277; HB 237

Section 1033 provides for the nonrecognition of a cash sale which is followed by a reinvestment within two years, if the cash sale qualifies as an involuntary conversion. Section 1033 requires the two properties to be of similar or related in service or use. This standard has been interpreted as more demanding than the like-kind standard of 1031. The policy justifications is generally continuity of investment with the fact that the taxpayer did not voluntarily sell his property. To the extent the taxpayer does not reinvest the proceeds of the involuntary conversion, the taxpayer is taxed.

Hypo: What if X owns land with a basis of $250,000 which is condemned for public use. X receives a condemnation award of $600,000. X buys property with FMV of $560,000. X finances the purchase with $400,000 cash and a mortgage of $160,000. Xs recognized gain is $40,000. The statute says the recognized gain is the amount realized minus the cost of replacement property.

4. Permanent Exclusion of Gain on the Sale of a Principal Residence

The general rule is that loss realized from sale or other disposition of the taxpayers personal-use property is not allowed. See IRC 165(c). A loss on the sale of taxpayers personal use property, such as a personal residence, jewelry, or a horse, is not allowed. However, gains on the sale of personal-use property are usually taxed.

Section 121 is the only permanent exclusion of realized gain in the code. Section 121(a) provides that gross income does not include up to $250,000 of gain ($500,000 for married individuals filing a joint return) on the sale or exchange or property, if, during the 5 year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as his principal residence for periods aggregating 2 years or more. The exclusion is not available if the individual has engaged in another sale of a principal residence resulting in exclusion of gain within the preceding two years.

For a couple filing a joint return, the couple must meet the following conditions:

a) Either spouse meets the requirement of owning the property for two years out of the last five years.

b) Both spouses meet the requirement of using the property as their principal residence for two years out of the last five years.

c) Neither spouse is ineligible for the exclusion because of having engaged in another sale of a principal residence resulting in exclusion of gain within the last two years.

If the taxpayer does not meet the ownership or residence requirements a pro rat amount of the $250,000 or $500,000 exclusion is allowed if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. To qualify for this pro rata exclusion, according to Temp. Reg. 1.121-3T, the primary reason for the sale must be employment, health problems, or unforeseen circumstances. Factors relevant for determining taxpayers primary reason include: (1) the sale and reasons for the change are proximate in time, (2) the suitability of the property as a principal residence materially changes, (3) the taxpayers financial ability to afford the residence materially changes, (4) taxpayer used the property as a residence during his ownership, (5) circumstances giving rise to the sale or exchange were not foreseeable, and (6) circumstances giving rise to the sale or exchange occurred while taxpayer used the property as a principal residence. Examples of unforeseen circumstances include: involuntary conversion of the residence, natural or man made disasters, including acts of war, death of taxpayer or family member, divorce or legal separation, or multiple births.

To calculate the pro rata exclusion: First calculate the number of months the taxpayer lived in the house divided by 24 months (the 2 year requirement). Multiply this ratio by $250,000 ($500,000 in the case of a joint return).

If one spouse meets the requirements but the other doesnt, the spouse who meets the requirements gets an exclusion of $250,000 which is aggregated with the other spouses pro rata exclusion as calculated above (assuming she meets the requirements of selling for employment, health, or unforeseen circumstances).This provision is great for someone who moves into a home, remodels it and sells it two years later for a gain within the exclusion amount.

Prior to 121, there was 1034 which was not a permanent exclusion but rather a deferral provision which allowed no gain to be recognized on the sale of a principal residence if a new residence was at least equal in cost to the sales price of the old residence. The problems with this was that it encouraged people to buy more expensive houses and locked in wealth.

D. Installment SalesThere are several reasons why a seller might agree to sell property through an installment sale: (1) the buyer is a small business has a lot of goodwill which is hard to value and a loan would be too risky for the bank; (2) the buyer does not have good credit; or (3) the seller doesnt mind taking the property back if the buyer defaults.

The issue in installment sales is recovery of basis. There are three options for recovery of basis: (1) allow the taxpayer to recover basis up first (this is taxpayer friendly because it defers taxation); (2) allow the taxpayer to recover basis last (very government friendly); (3) pro rata recovery. Section 453 allows a pro rata recovery of basis. Section 453(c) gives the following equation (X is the taxable amount, P is the payments received that year, GR is the gain realized on the sale, and CP is the contract price):

X = P(GR/CP)

Section 453 applies only to principal payments, interest payments are included in the gross income of the seller as ordinary income. If the note does not contain stated interest Original Issue Discount Rules (OID) apply. Just know that OID exists.

E. AnnuitiesSimilar to installment sales, Congress has provided a gradual recovery of an annuitants basis according to the exclusion ratio of 72(b)(1). This equation is (X is the nontaxable amount; P is the annuity payment; I is the investment in the contract; E is expected return):

X = P(I/E)

Section 72(c)(1) says the investment in the contract equals the premiums paid by the taxpayer reduced by any amounts received by the taxpayer before the annuity starting date and excluded from income. Section 72(c)(3) doesnt define expected return but says that if the expected return depends on the annuitants life expectancy, the expected return is to be based on Treasury actuarial tables.

The exclusion is limited to the investment. After the taxpayer recovers her investment, she has to include the entire annuity payment in income. If the taxpayer dies before her investment is recovered, the amount of the unrecovered investment is allowed as a deduction in the taxpayers last taxable year. Under 72(b)(3)(C), this deduction is treated as a NOL (this allows the taxpayer to carry the loss back two years).

F. Basis Rules for Property Transferred by Gift or Bequest

1. Property Transferred by Inter Vivos Gift

There are three options for taxing a gift: (1) treat gift as a realization event and tax gain, donee would get property with a basis at FMV; (2) carry-over basis, donee receives donors basis and is taxed on the gain when the donee sells; or (3) tax the donor when the donee sells on gain up to point of transfer and tax donee on gain after transfer.

Section 1015 states that the donors basis is carried over to the donee. However, if FMV at time of transfer is lower than basis and the donee eventually sells for a loss, then FMV at time of transfer is used as basis.

The following is a notch transaction:

D gives X stock with a basis of $100 and FMV of $90. X sells the stock for $95. If you apply gain rule (give X the carry-over basis) the basis is $100 and there is a loss of $5. If you apply loss rule (give X the FMV at transfer) the basis is $90 and there is a gain of $5. In this situation, there is no gain or loss. See Treas. Reg. 1.1015-1(2).

This section does not apply to transfers between spouses; 1041 applies.

2. Property Transferred at Death

A transfer at death is not treated as a realization event, and 1014 gives the transferee a basis equal to the propertys value as of the decedents death. This provision hurts people who die unexpectedly or with poor advice (basis of property with a loss is stepped down to the FMV).

One argument is that it might be difficult to determine the basis of property since the person who probably knew is now dead.

3. Part Gift, Part Sale Transactions

Under Treas. Reg. 1.1001-1(e), if a transfer of property is part sale and part gift, the transferor has a gain to the extent the amount the transferor receives exceeds his basis. For instance if X has property with FMV of $400,000 and basis of $60,000 and X transfers the property to D for $100,000, X has a gain of $40,000 ($100,000 - $60,000). Ds basis would then be determined by Treas. Reg. 1.1015-4. For a bargain sale to a charitable organization, see 1011(b).

G. Basis Allocation: Piecemeal Asset Dispositions and Other Contexts: CB 294

Gamble v. Commissioner CB 294

The taxpayer bought a pregnant mare for $60,000. The foal the mare carried was believed to be sired by a horse whose yearlings sold for an average of $50,000 each. The taxpayer insured the foal with $20,000 insurance before the foal was born and $30,000 after the coal was born. Taxpayer sold the colt for $125,000. The taxpayer argued that $30,000 of the $60,000 paid for the mare was for the colt and therefore his basis in the colt was $30,000 (the taxpayer argued that this was approximately the stud fee). The IRS argued that the entire $60,000 was for the mare and the taxpayer had no basis in the colt. The court held the basis was $20,000 because that was what the amount the taxpayer insured the colt.

There are several ways the taxpayer could argue that value of the foal (and therefore basis allocation) before birth (at the time of taxpayers purchase of the mare): (1) get breeder to estimate value of the foal; (2) cost of breeding (taxpayer lost in this case); or (3) more than the cost of breeding because stud fee only gives a chance of a foal, here a foal existed.

Gamble shows the problem with basis allocation. This allocation problem can also arise when a taxpayer purchases land with a building. The taxpayer (assuming it is for business) can take a deduction for depreciation of the building but cannot take depreciation for the land. How much should be allocated to the building and land?Treas. Reg. 1.61-6(a) states that the basis has to be equitably apportioned among the several parts. One way is to use appraisers to appraise the value of the several parts.

IV. Personal Deductions

Personal deductions usually refer to those deductions that are available only to individual taxpayers. There are above the line deductions which are subtracted from income to reach adjusted gross income (AGI). Then there are itemized deductions. Itemized deductions can only be taken if the taxpayer does not take the standard deduction.

A. Charitable Contributions ( 170): CB 356; HB 519

1. The Rationale

One reason for the charitable contribution deduction is to encourage taxpayers to support charitable organizations. This can be justified because the government is relieved of an obligation it would otherwise have had to meet, or on grounds that the charitable organization provides a general public benefit. However, the charitable sector includes organizations which Congress could not be persuaded to support or which Congress would not be permitted to support under the Constitution. Second, taxpayers in the higher brackets have a greater incentive because the tax savings per dollar donated depends on the taxpayers marginal tax rate. Finally, it is not clear that allowing deductions for contributions actually results in greater charitable giving.

Another justification is that a charitable deduction is an accurate reflection of income because the taxpayer does not have the consumption of the charitable gift.

Treas. Reg. 1.170A-1(g) states that [n]o deduction is allowed under [] 170 for a contribution of services. For example, if X is a magician and donates a show to a childrens hospital, X does not get a charitable deduction, but also consider that the show is not included in Xs income because this is imputed income.

2. The Amount of the Deduction

The taxpayer gets a deduction of FMV regardless of the taxpayers basis. For example, if X gives charity stock with a basis of $10,000 and a value of $100,000, by logic, the deduction should be $10,000 (because this is what was previously taxed) but X can take a deduction on $100,000 (even though X never paid tax on $90,000). See Treas. Reg. 1.170A-1(c)(1).

In most cases, the unrealized gain in donated property is deductible only if:

(1) The gain would have been long-term capital gain had the taxpayer sold the property;

(2) In the case of a contribution of tangible personal property, the use of the property by the charity is related to the charitys tax-exempt purpose; and

(3) The property is not given to a private foundationOtherwise, the charitable deduction is limited to the taxpayers basis in the property.

If the property has a claimed value of more than $5,000, the taxpayer has to obtain an appraisal.

3. Eligible Recipients

Section 170(c) defines the eligible organizations to which deductible contributions can be made. It substantially tracks 501(c)(3) which is the exemption from federal tax for charitable organizations.

4. Limitations on Deductions and Carryovers

There are limits to the amount a taxpayer can deduct depending on the type of charity, the type of property contributed, and the type of transfer. The limits are a percentage of the taxpayers contribution base which is the taxpayers AGI computed without regard to any NOL carryback.

There are two types of charities: (1) charities to whom the taxpayer may contribute up to 50% of his contribution base; and (2) charities to whom the taxpayer may contribute up to 30% of his contribution base.

50% charities include: churches or associations of churches, schools and colleges, hospitals, medical schools or medical research organizations, organizations receiving a substantial part of their support from the state or federal government or the general public, the state or federal government, and certain private foundations. See 170(b)(1)(A) and Treas. Reg. 1.170A-9. 30% charities are those organizations qualified to receive deductible charitable contributions but do not qualify as 50% charities. See 170(b)(1)(B).

If a taxpayer makes contributions to both 50% and 30% charities, the amount of the contributions to the 50% charities are taken first. If those contributions have not exhausted the limit, the contributions to the 30% charities, up to 30% of the contribution base, or the remaining amount on the 50% limit whichever is less, are allowed.

Contributions to 50% charities which exceed 50% of the contribution base may be carried forward for 5 years. Contributions to 30% charities which exceed 30% of the contribution base cannot be carried forward.

If the taxpayer contributes capital gain property, it may be deducted only to the extent it does not exceed 30% of the taxpayers charitable contribution base. See 170(b)(1)(C)(i).

Charitable contributions have to be substantiated according to the regulations. In addition, the taxpayer has the burden of establishing that a charity qualifies for the receipt of deductible contributions.Corporate taxpayers can deduct up to 10% of their taxable income, computed without regard to their charitable gifts, their dividends-received deduction, and any carrybacks for capital or operating losses. See 170(b)(2).

5. Vehicle Donations

To stop abuse of donations of used automobiles, Congress enacted 170(f)(12). First, taxpayers are only allowed to deduct contributions if the charity provides a contemporaneous written acknowledgement of the donation. The acknowledgment has to give the gross proceeds of the sale of the vehicle and a statement that the deductible amount may not exceed the gross proceeds. This provision does not apply if the charity is going to use the vehicle as part of its charitable mission (e.g. to deliver meals, services, etc.).

6. Quid Pro Quo

The quid pro quo principle is that a deduction is not allowed for a contribution to charity where a person receives some benefit from the contribution.

a. The College Football Saga

In Rev. Rul. 84-132 CB 406, the IRS declared that a taxpayer who paid money to an athletic scholarship program and was, because of the donation, entitled to buy football tickets for preferred seating, was not a charitable deduction. As a general rule, payment to a charitable organization which results in the receipt of a substantial benefit creates the presumption that no charitable contribution has been made.

In 1986, Congress created a rifle shot provision for LSU and Texas, allowing deductions for their football programs. In 1988, Congress leveled the field by enacting 170(l) which allows 80% of a gift to be deducted if the gift entitles the taxpayer to purchase seating at athletic events.

b. Intangible Religious BenefitsRev. Rul. 70-47 allowed the charitable deduction of pew rents. Rev. Rul. 78-189 denied charitable contributions by taxpayers to the Church of Scientology for a fixed donation made to the church for payment of auditing courses unless the taxpayer can prove that the donation exceeded the FMV of the benefits received. In that case, the taxpayer could deduct the excess of FMV donated.

Hernandez v. Commissioner CB 413

The taxpayer argued that the fixed d