Spring 2012 Tax OutlineI. What is income?

a. §61 defines income as “income from any source derived.”i. Very EXPANSIVE phrasing: “Including, but not

limited to…” enumerated categories.ii. Eisner v. Macomber (1920) held that income within

the meaning of the 16th Amendment was gain from labor, capital, or the combination of the two.

iii. Glenshaw Glass (1955) overturned Eisner and held essentially that income is what congress says it is – very deferential to Congressional interpretation.

1. “Any accession to wealth clearly realized over which the taxpayer has dominion.”

2. Lost profits awarded in a lawsuit clearly are taxed as if earned initially – subject to income tax.

b. Where are tax cases adjudicated?i. U.S. Tax Court – Hears 95% of tax disputes. – This

is a PREPAYMENT tribunal where you can litigate with the federal government without having to first pay the tax.

ii. Court of Federal Claims AND US District Courts – Both are REFUND tribunals.

iii. Treasury can pass regulations interpreting the statute, which taxpayers can challenge. However, if treasury’s interpretation is reasonable then it will prevail based upon Chevron deference.

c. Non-Cash Benefits Generally will be subject to tax based on the FMV of the non-cash benefit received.i. Old Colony Trust (1929) – If a company pays income

taxes on behalf of an employee then the amount of tax paid must also be treated as income to the employee.

d. EXCEPTIONS to General Non-Cash Benefit Rule:i. §119(a) Meals and Lodging Furnished for the

Convenience of the Employer – Excluded from Gross Income.

1. Meals – only excluded if provided on the business premises.

a. Treasury Regulation §1.119-1: Two Prong Test: (1) On business premises, and (2) For Convenience of employer [determined by facts NOT statements of the parties].i. Requires the meals to be furnished

for a substantial noncompensatory business reason.

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1. Generally meals furnished before or after working hours will NOT be seen as for the convenience of the employer.

a. Examples Non-compensatory business reasons:

b. Furnished to the employee during working hours to have employee available for emergency call during a meal period.

c. Meal periods are so short that employee cannot reasonably be expected to leave the premises to secure his own meal.

d. Restaurant employees on duty during meal periods meet the exception.

e. COMPENSATORY BUSINESS REASON if goal is to raise morale.

2. Lodging – only excluded if employee is REQUIRED to accept the lodging as a condition of his employment.

a. Treasury Regulation §1.119 three prong test: (1) Lodging is furnished on the business premises, (2) lodging is for the employer’s convenience, and (3) employee is required to accept lodging as a condition of employment.

ii. §132 – Fringe Benefits [Excluded from Gross Income]

1. (b) No-additional Cost Service – Service is provided by employer in the regular course of business AND can be provided to employee without additional cost to employer, including foregone revenue.

a. Can cover employee, spouse, and dependent children.

b. Air transportation allows the parent of employee to be included as well.

2. (c) Qualified Employee Discountsa. Products – Discount cannot exceed gross

profit % for which item is sold to public.

b. Services – Discount cannot exceed 20%.

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i. Product/Service discounts can cover employee, spouse, and dependent children.

iii. (f) Qualified Transportation Fringe – Can exclude parking and transportation passes.

iv. (j) No additional cost service and employee discount exceptions ONLY apply to highly compensated employees if the policy also non-discriminatorily covers non-highly compensated employees.

1. (j)(4) If a gym is operated by employer on premises for benefit of employees then the value of the “membership” can be excluded from the employee’s gross income.

e. §106 - Employer Provided Health Insurance – Not included in the employee’s gross income.

f. Imputed income – the economic value of services provided for oneself or the use of one’s own property, which is NOT recognized as taxable income (ex. homemaker or living in an owner occupied house).i. Revenue Ruling 79-24: If services are paid for

other than in money, the FMV of the property or services taken in payment must be included in income (i.e., the use of barter rather than cash will not make the thing received not be treated as income).

1. Treasury Regulation §1.61-2(d): If property is transferred to an employee in exchange for less than its FMV than the difference between the FMV and the amount paid must be included as income.

a. When services are exchanged the tax due will be based upon the FMV of the services received even if said services were NOT of equal value. However, if the FMV of one but not the other was readily ascertainable then the known value may be used as evidence that the other had the same value.

b. FMV tax system dreams up an arm’s length transaction between unrelated parties.

g. Treasure Trove Regulations: If you find something of value, ex. a Barry Bonds homerun ball you will be taxed on the FMV of the item you discover.i. If you pay tax on the FMV of the item in year 1

(ex. $200k) then sell it in year 4 for a profit

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(ex. $800k) – your basis in the ball will equal the amount that you paid tax on in year 1 ($200k).

h. §102 – Gifts and Inheritances: Gross income does not include the value of property acquired by gift.i. Gift = something of value transferred without

consideration.ii. §102(c) Any amount transferred from an employer to

or for the benefit of an employee shall NOT be considered a gift.

iii. §274(b) – If a gift can be excluded from income by the recipient under §102 then any value over $25 cannot be written off as a business expense.

1. Thus a gift from an employer to an employee, which cannot be a gift for purposes of §274(b) because it cannot be excluded under §102(a) per §102(c) is deductible for the employer.

iv. Duberstein (1960)– Gave a business associate a Cadillac to thank him for sales leads, but he was under no contractual obligation to provide any compensation.

1. Stanton (1960) – At conclusion of employment he was given a $20,000 severance/pension that was NOT legally owed to him.

2. In BOTH cases SCOTUS refused a per se rule that business-related transfers can never be a gift, but held that the intent of the donor is key: was it motivated by detached and disinterested generosity?

3. NOTE: §102(c) was passed after the Duberstein and Stanton cases to create the per se ban for employer to employee transfers.

i. Transfer of Propertyi. §1014(a) – Stepped up basis at death.

1. §1014(b)(6) If owned as CP then the entire property value will get a stepped up basis with the death of either spouse.

2. §1014(e) Anti-fraud provision if acquired by deceased person in the last year of his life and it goes back to the one who gave it to him then there will be no stepped up basis at death.

3. Can actually be a step up OR down at death, but usually only a step up because taxpayers will usually sell loss properties prior to death to “harvest” the tax loss.

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a. Incentive is to hold appreciated property and to sell depreciated property.

ii. §1015(a) – Basis of Property acquired by Gift: Basis shall be the same as it would be in the hands of the donor, EXCEPT if the basis is greater than the FMV at the time of the gift then for the purpose of determining loss the basis will be the FMV at the time of transfer.

1. HYPOS: A buys stock for $1,000 and gives to B When worth $2,500.

a. B sells for $3,500 $2,500 gain based on A’s $1,000 basis.

b. B sells for $1,500 $500 gain based on A’s $1,000 basis.

c. Sells stock for $300 $700 loss based on A’s $1,000 basis; exception in §1015 does NOT apply to this situation.

2. HYPO: C purchases stock for $2,000 then gives to D when worth $1,000.

a. $2,500 sale $500 gain based on C’s $2,000 basis.

b. $500 sale $500 loss based on FMV at time of transfer.

c. $1,500 sale NO GAIN OR LOSS: Less than adjusted basis [$2,000], but more than FMV at the time of transfer [$1,000].

3. HYPO: $80,000 for S to go to college, most tax favored way to transfer to S? D is in top marginal tax rate and S has no income.

a. Stock with basis of $20,000 and a FMV of $80,000 Give to S, he will pay tax but at a lower marginal tax rate.

b. Stock with a basis of $120,000 and a FMV of $80,000 Sell stock to realize the loss then give S $80,000.

c. Stock with a $20,000 basis, FMV of $80,000 and $80,000 cash Keep the appreciated stock and give away the cash.

d. Basis of $20,000 and a FMV of $80,000, also other stock with a basis of $120,000 and a FMV of $80,000 Sell stock #2 for the loss and let the gain on #1 “ride.”

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e. If “near” death hold on until death so S can receive stock tax free due to the §1014 stepped up basis.

iii. §1001 – Computation of gain or loss.1. Gain = Amount realized – adjusted basis.2. Loss = Adjusted basis – amount realized.

a. Either way the number will always be POSITIVE.

iv. §1012 – Cost Basis of Property – Generally basis will be the cost of property unless otherwise provided.

j. Recovery of Capital – Income includes returns from the sale of one’s capital, but NOT the recovery of the initial amount invested (which is where basis comes in).i. §72: Annuities, Certain proceeds from life

insurance contracts – Exclusion ratio divide the amount invested by the expected return to get the exclusion ratio. Then upon each receipt of payment the amount received times the exclusion ratio will be the amount reported as income.

1. Ex. Invest $25,000, expect return of $100,000. Exclusion ratio will be (25,000/100,000) or 25%. If each payment is for $10,000 then the taxable amount will be $7,500 [excluding 25% of each payment].

2. Once the entire investment has been recovered (ex. $25,000) then the exclusion ratio will no longer apply and the entire payment will be subject to income tax.

a. If annuitant dies prior to recovering entire basis then the unrecovered amount can be excluded in total on the decedent’s final tax return.

b. If return depends on the life of the annuitant than expected returns shall be calculated using actuarial tables.

ii. Treasury Regulation §1.61-6: When a part of a property is sold the cost or basis of the entire property shall be equitably apportioned amongst the parts. The amount realized for the sold portion will be calculated based upon the portion of the basis allotted to that specific parcel.

1. Inaja Land (1947) If determining the portion of the basis for a particular property right sold is impracticable or impossible then no tax will immediately be due, but the basis of

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the entire parcel will be reduced by the amount received.

iii. Basis is a way of taking into account one’s initial investment so that upon a subsequent sale tax is only paid on the gain or loss (i.e., the difference).

1. The taxpayer wants the basis to be as high as possible because that is a shield from potential future tax liability.

k. Timing of tax is key because to defer the payment of tax is to systematically lower the effective tax rate on the income that is eventually taxed (assuming constant tax rates over time).

l. §165 – Losses: For individuals deductions are limited to losses incurred in a trade or business, transactions entered for profit, or arising from “fire, storm, shipwreck, or from other casualty.”i. Clark (1939) – Taxpayer overpaid taxes in a prior

year by $19,000 due to bad advice by his CPA. The CPA subsequently paid the money over to taxpayer to make up for the mistake. Court held that the recovery was NOT taxable because it was the recovery for an earlier non-deductible loss, taxpayer was merely made whole.

1. In order for Clark to apply there must be a conceptual nexus between the loss and the money acquired. Normally a deduction could offset any $19,000 of income, BUT since here there is no deduction there has to be a specific nexus between the loss and the subsequent gain.

a. In Clark the exclusion would only apply for a recovery coming from the negligent tax adviser. If instead, he had found $19,000 that would not be shielded and would be subject to tax despite the uncompensated loss.

2. The court distinguished this case from Old Colony Trust where an employer voluntarily paid the taxes of its CEO, which was found to be additional income paid to the CEO (thus the amount paid in taxes was also subject to tax).

3. IF the prior loss had been deductible AND claimed then upon recovery the taxpayer would have to report the amount received as income per the TAX BENEFIT RULE.

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m. §172: Net Operating Loss (NOL) Deduction – Can be carried back 2 years OR forward 20 years.i. §172(c) requires NOL to be calculated before

factoring in any NOL deductions because otherwise the time restrictions would have no impact.

ii. This is Congress’ attempt to soften the sometimes harsh results that the annual “snapshots” we use for income tax purposes may impose when there is unsteady income from year to year.

iii. Sanford & Brooks (1931) – Taxpayer lost money for three years on dredging contract. They subsequently sued the other party for breach of warranty and recovered the amount they previously lost ($176,000). Taxpayer argues the judgment just made them whole so there should be no tax consequences. Court rejects argument based on annual accounting periods: no matter what happened in 1916-1919, in 1920 they gained $176,000 because the US uses annual as opposed to transactional accounting.

1. NOTE: This case, while still good law, would not have nearly the same harsh effects now due to §172’s NOL provisions.

n. §1341: Claim of Right – If a Claim of Right recognized in a prior year must be returned (and the deduction is greater than $3,000) then the taxpayer is entitled to deduct the greater of (1) the tax savings from using the deduction normally on the present return, OR (2) the amount of tax paid in the prior year with the claim of right included minus what would have been due without the claim of right [i.e., the original amount overpaid] i. North American Oil Consolidated (1932) – Receiver

appointed over taxpayer’s business in 1916, in 1917 District Court sided with NAOC and profits from 1916 in the amount of $172,000 were turned over. Final appeals of the decision were dismissed in 1922.

1. SCOTUS held that taxpayer had a “Claim of Right without restriction as to its disposition” to the money in 1917 so it had to be reported on the 1917 tax return. If subsequent events in 1922 (ex. losing the appeal) cause NAOC to lose its claim then in 1922 it would be entitled to a deduction.

a. NOTE: The general rule is still true, but the results that may come from

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different marginal tax rates in different years are softened via §1341.

2. This is NOT a proper situation for filing an amended return because there was NO MISTAKE based upon the facts that were known at the time the return was filed.

ii. Lewis (1951) – Employee received a $22,000 bonus in 1944 and paid taxes on that amount. In 1946 it was determined that he was only supposed to receive ½ of the bonus so he returned $11,000. Court held he was entitled to an $11,000 deduction in 1946, but he was NOT able to amend his 1944 return because at the time his return was accurate based on his Claim of Right.

o. §111: Recovery of Tax Benefit: An amount recovered that was previously deducted will NOT be included in income during the present year if it did NOT reduce the tax paid by the taxpayer in the year that the deduction was originally claimed.i. EXCLUSIONARY TAX BENEFIT RULE – No need to report

income on an amount previously deducted if it did NOT originally save the taxpayer money in the year it was originally deducted.

ii. INCLUSIONARY TAX BENEFIT RULE – If the prior deduction did save the taxpayer money and then is subsequently recovered it must be included in income for the year in which it is recovered.

iii. §111(c) if the deduction did NOT reduce tax liability in the year that it was taken, BUT did create or enlarge a NOL it will be treated as a tax benefit for purposes of §111. Thus the present recovery must be included in income.

iv. The Tax Benefit Rule can be seen as the opposite of the Claim of Right.

1. Claim or Right – Tax first then deduction when assumptions prove wrong.

a. Sensitive to differential rates over time by virtue of §1341.

2. Tax Benefit – Deduct first then pay tax when assumptions prove wrong.

a. Applies regardless of whether or not differential rates over time will benefit or disadvantage the taxpayer.

p. §104: Compensation for Injuries or Sickness – The amount of ANY damages received for personal injury or sickness (whether paid in a lump sum or periodic payments) is excluded from income. BUT, emotional

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distress shall not be treated as a physical injury/sickness except to the extent that the recovery is being used to cover ACTUAL medical bills.i. Lost Profits – Taxed in the same manner the

original profits would have been taxed included in income.

ii. Damaged Property – Treated as a forced sale (involuntary conversion). Absent a special rule, you will be treated as if the property had been sold voluntarily.

1. §1033 provides an exception if you reinvest the proceeds in “similar use” properties.

iii. IF medical expenses are deducted in one year then a subsequent judgment awards money for those expenses – despite §104(a)(2) the judgment will be taxable under the Tax Benefit Rule.

iv. Emotional distress damages are specifically excluded under the statute except to the extent they cover actual medical costs (i.e., therapy bills), unless previously deducted because the Tax Benefit Rule would then require the recovery included in income.

1. If someone else was injured physically then it could be argued that the “soft” emotional distress damages are excludable from income: the statute is ambiguous based on the language “on account of personal injury” and does NOT explicitly say “his personal injury.”

v. Victim of personal injuries can exclude ALL recoveries except punitive damages from income. Thus lost wages will NOT be taxable even though the wages would be taxed if earned.

1. Medical expenses included in recovery will only be included in income if required by the Tax Benefit Rule.

a. NOTE: Deduction of medical expenses under §213 has a very significant floor of 7.5% of AGI.

q. §104(a)(2)’s allowance to be paid in “lump sums or periodic payments” incentivizes people to create structured settlements because the interest component of the settlement will be excluded from income, but if a lump sum was paid out then invested the investment proceeds would be included as income.

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r. §108 – Specific exclusions from the general rule under §61(a)(12) for income from the discharge of indebtedness. i. NOTE: Generally speaking loan proceeds are NOT

income and loan payments are NOT deductible.ii. CoD Income = Cancellation of Debt Income.iii. Kirby Lumber – Company issued $1M worth of bonds

and bought them back for $800k. Court found that company had CoD Income in the amount of $200k.

iv. §108(b) while CoD income can be excluded in some cases (See §108(a)) it will be used to offset other tax attributes under the basic theory that if the taxpayer ends up prosperous then the CoD income should properly be taxed despite §108(a)’s general relief provisions.

1. “Catch all” provision is reduction of basis of other property owned by the taxpayer, which §1017 will require that portion of the tax on a subsequent sale to be paid as income tax instead of the usual capital gains tax rates.

v. Among other things §108(a) eliminates CoD income when debt is discharged in bankruptcy; property-mortgage work out agreements will have NO CoD income, but will adjust the basis; renegotiation of a purchase price by a solvent debtor will be seen as a purchase price reduction (and affect basis) but there will be NO CoD income.

vi. Zarin – Taxpayer disputed a debt he owed to a casino because he claimed it was unenforceable. The $3.5M debt was subsequently settled for $500k. The court held that since the debt was in dispute the amount of debt was properly fixed by the settlement so there was no CoD income realized.

1. Contested Liability Doctrine If the debt is disputed in good faith, a subsequent settlement will be seen as the true debt for tax purposes.

a. I.e., it really was a $500,000 debt that was paid in full.

s. §103 – Income from state and local bonds are excluded from gross income.i. In theory, the market will simply discount for

this advantage by offering lower interest rates; however, there may still be some advantage for tax payers in the higher marginal tax brackets

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depending on the discount rate applied by market forces.

ii. The exemption is provided by statute, but there is no Constitutional barrier to taxing proceeds from state/local bonds per South Carolina v. Baker.

t. §121 – Gain from the sale of a principal residence can be excluded up to $250,000 ($500,000 if married) if the taxpayer lived there for 2 of the last 5 years.i. §1012 – Basis rules for capital assets.

II. When is it income?a. Eisner (1920) dealt with Constitutional realization

requirements, which have subsequently been overturned. However, realization is still important because of statutory requirements set by Congress in the Internal Revenue Code.i. Delayed realization drives down the effective rate

of taxation over time due to the time-value of money.

ii. Also, incentivizes people to hold appreciated assets to avoid realization and to sell depreciated assets to realize the loss for tax purposes.

1. §1091 – Designed to prevent people from selling depreciated assets to realize the loss then immediately buying them back. If done within 60 days of the sale the deduction for the loss will not be allowed.

a. Designed to combat strategic behavior by taxpayers who have sole control over when capital assets will be subject to tax.

iii. Realization v. Recognition - §1001(c)1. Realization – References the underlying

transaction (sold, purchase, exchange, etc.)2. Recognition – The realization must be

reported on your tax returns.3. Usually the two go hand in hand where

realized gains or losses will also be recognized; however, Congress can pass non-recognition rules that allow certain realizations to not have to be recognized/reported on one’s tax return.

a. Non-recognition rules are usually used to defer rather than eliminate tax burdens.

b. Often times tax lawyers work to help clients to come as close as possible to selling an asset (i.e., to

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monetize it) without triggering a realization event and the accompanying tax consequences.i. Goal in many cases is to either 1) mimic a sale by

changing economic circumstances without facing tax consequences, or 2) to trigger a sale for tax purposes, but NOT change the underlying economic circumstances.

ii. Taking out a loan against an asset is NOT a realization event.

iii. Zero Cost Collar: Sell a call option, buy a put option, and borrow against the asset.

1. Ex. ADBE stock worth $100M: Sell a call option for $110M, buy a put option for $90M THEN borrow against the secure economic position [$90M - $110M].

c. §1001 – Determination of amount realized shall take into account the amount of money AND the FMV of any property received.

d. Cottage Savings (1991) – Taxpayer wanted to trigger a sale for tax purposes, but avoid one for accounting purposes.i. Taxpayer unsuccessfully tried to argue against the

regulations adopted by the IRS, which is an uphill battle in light of Chevron deference. However, while SCOTUS deferred to the IRS regulations it did NOT defer to the IRS’ litigation positions interpreting the regulations.

ii. SCOTUS holds that when there is a change in legal entitlements even when the assets exchanged are essentially the same economically there is a realization event. THUS it is EXCEPTIONALLY EASY to trigger a realization event.

1. NOTE: §108 Excludes the renegotiation of mortgages from CoD income because otherwise it could be seen as a realization event due to the changed legal rights/circumstances.

e. §1031 – Like-Kind Exchanges of Real Propertyi. Exchanged properties will almost never have the

same value so one party often has to kick in something extra (often cash) to even out the transaction – called a boot. Per §1031(b) the boot is taxed based upon its FMV – no deferral on the boot because non-recognition is limited to “qualified property.”

1. If NO boot is received then no gain has to be recognized, BUT if boot is received than gain

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must be recognized but only to the extent of the boot’s FMV.

ii. HYPO: Dick Cheney owns a Building with a FMV of $100 and a basis of $60; Snookie owns a Ranch with a FMV of $90 and a basis of $75.

1. Snookie will have to transfer the Ranch AND $10, Dick Cheney will transfer the Building (both parting with $100).

a. Snookie fits neatly within §1031(a) – Like-kind property given up solely for like-kind property. [She realizes a gain of $15 ($100 FMV of building - $10 boot = $90 - $75 basis in ranch = $15); however, $0 is recognized per §1031(a).i. Basis in ranch will be $85 ($75

transferred basis + $10 boot).ii. Goal of §1031 is to preserve the

$15 of built in gain that she had before the transaction – merely a deferral provision.

b. Dick Cheney is getting Boot of $10 AND the Ranch. Realization of $40 ($100 purchase price - $60 basis = $40).i. Recognition under §1031(b) will be

$10, must recognize gain, BUT only to the extent of boot received.

ii. Basis in the Ranch will be $60 ($60 transferred basis + $10 recognized THEN - $10 boot received = $60).

iii. Goal is to preserve his $30 of built in gain ($40 of gain originally, but he already recognized $10 of it). Ranch: FMV $90 - $60 basis = $30 built in gain.

1. NOTE: DO NOT SKIP THE STEP of transferred basis plus gain recognized minus the amount of boot received because in some cases the numbers will be different so it makes a difference CANNOT assume it will merely be a “wash.”

2. Key things to check: (1) How much gain have you recognized? [It will NEVER be more than the amount realized.], and (2) The amount of gain recognized will be the lesser of the

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amount of boot received OR the amount realized.

a. THUS if no gain is realized but there is a boot the boot will NOT be subject to tax.

3. In the real world these will NOT be exchanges but rather a sale followed by a reinvestment of the proceeds in a new property. Boot will be any proceeds NOT reinvested into the second property.

iii. Intangible legal rights such as negative easements can be seen as like kind when exchanged for real property so long as the intangible legal right is seen as an interest in real property under the substantive state law the IRS defers to state law in this regard.

iv. Strict timing requirements must be met to take advantage of §1031’s non-recognition provisions failure to meet provisions will subject transaction to the general requirements of §1001.

f. Methods of Accountingi. Cash Method – Income is taken into account when it

is received. Deductions are taken into account when paid.

1. Because it is based upon receipt/payment it is subject to strategic manipulation to minimize tax liabilities.

2. Treasury Regulation §1.451-1 and 2 – income must be recognized upon the FIRST of real or constructive receipt.

a. Constructive receipt occurs when the money is made available to the taxpayer to take at anytime of his choosing.

b. Amend (1949) – Tax Court found NO constructive receipt when taxpayer was NOT entitled to immediate payment under the contract even though he could have negotiated for immediate payment when the contract was formed. – The legal rights are the key issue.

c. Pulsifer (1975) – Lotto proceeds were placed in a trust account for minors, but was accessible upon the application of their parent/guardian. Court found constructive receipt.

d. Alternative approach: ECONOMIC BENEFIT DOCTRINE – Money is currently taxable

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once the absolute right to income in the form of a financial benefit is derived from the absolute right to income in the form of a fund that has been irrevocably set aside for him in trust beyond the reach of the payor’s creditors. i. The receipt of the absolute right

to future payments is seen as present income.

ii. Planning around the economic benefit doctrine requires the payor to make commitments that are as secure as possible for the payee, BUT NOT so secure as to trigger the doctrine.

3. ***Use this cash method for the exam ***ii. Accrual Method – Income is taken into account when

earned even if NOT received yet. Deductions are taken into account when the expense is incurred.

g. Non-Qualified Deferred Compensationi. Minor (1985) – Economic benefit doctrine does NOT

apply when employee is NOT the beneficiary of the trust – rather the corporation is and will subsequently remit payment to the employee. Key difference because upon receipt by the corporation, the employee’s claim to the money will have to compete with those from the firm’s other creditors.

1. IF the trust paid the employee directly then the Economic Benefit Doctrine would apply and the employee would be subject to present tax.

2. HYPOS:a. Player named as beneficiary of Trust

worth $600,000 Subject to PRESENT tax. Taxed upon $600,000 immediately, which will give him a basis of $600,000 in the annuity contract.

b. Player named as beneficiary of trust worth $600,000 AND will receive $400,000 of interest in five years Player taxed immediately on the $600,000 value of the trust AND taxed on the portions of the $400,000 in interest income as it is earned by the trust (even though the player will NOT get any payouts in years 1-4).

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c. Corporation is the beneficiary of the trust worth $600,000 with an expected interest accrual of $400,000 over 5 years No present taxation because the player will stand shoulder to shoulder with other creditors and thus has only a “mere promise to pay.”

d. Corporation AND owner guarantee to pay player $1M in five years No present taxation: two “mere promises to pay.”

h. Qualified Deferred Compensation:i. 401(k) and IRA: Deduction initially, tax free

growth, and taxable distributions.ii. Roth IRA: No initial deduction, tax-free growth,

and tax-free distributions.iii. If rates stay constant from year to year the

regular and Roth IRAs should theoretically produce identical results in terms of the amount of money available upon withdrawal for consumption.

iv. When investments are in EITHER type of IRA account then you don’t have to care whether it spins off ordinary v. capital income.

1. Can opt for better return because immediate tax consequences that normally would have to be considered can be disregarded.

2. If you are investing both inside and outside of an IRA – invest in the tax preferred assets (ex. municipal bonds) outside of the IRA to get the maximum tax advantage of both.

3. All income from an IRA will be taxed as ordinary income upon distribution – no distinction is made between capital and ordinary income upon distribution.

i. Consumption Tax: I = C + S (I = Income, C= Consumption, and S= Savings). Algebraically then C = I – S, which represents deductions for contributions to a qualifying account resulting in taxing that which is NOT saved (i.e., consumption).i. This is an alternative to a transaction based

consumption tax (i.e., sales tax). The consumption tax allows progressive rates to be applied unlike sales taxes, which are applied evenly across the board.

ii. Adopting this approach would also reflect a commitment to NOT taxing investment income.

j. §83: Property Transferred in Connection with Performance of Services – When property is transferred

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to a service provider for less than its FMV the difference will be taxable IF it is EITHER 1) transferrable OR 2) NOT subject to a substantial risk of forfeiture (which ever happens first).i. Property is subject to a substantial risk of

forfeiture if it is conditioned on the performance of substantial future services.

ii. §83(b) – Upon receipt the taxpayer can opt for immediate taxation based on the FMV – amount paid for the property.

1. HYPO: Employee granted $200,000 worth of LLC units that will NOT vest for 5 years. Should he make a §83(b) election?

a. Under §83(a) – No taxes on units until they vest thus tax NOT due until year 5. IF FMV in year 5 was $2.2M there will then be ordinary income of $2.2M in year 5 [$770,000 tax bill @ 35%]

b. Under §83(b) – Year 1 $200k of ordinary income [$70,000 @ 35%]. In year 5 when the vesting occurs there are no direct tax consequences, BUT upon sale if FMV was $2.2M - $200k basis so $2M of gain taxed as capital gains [$300,000 tax bill @ 15%]

c. Thus §83(a) has a total tax of $770,000 v. §83(b) has a total tax of $370,000.

iii. When do you want to make a §83(b) election?1. Low FMV initially.2. If you expect property received to appreciate

substantially.3. If you are fairly certain that you will

satisfy the vesting requirements. iv. Under §83(b) if the property is forfeited before

it vests, but tax was previously paid upon receipt (ex. $200k) there will be NO deduction for the amount of income that was initially received but subsequently forfeited.

v. §83(h) – Employer gets to deduct the amount that the employee includes in his ordinary income for the year that the employee reports said income.

vi. Cramer (1995) -§83(e)(3) states that §83 does NOT apply to OPTIONS without a readily ascertainable FMV.

1. Treasury Regulation §1.83-7(b)(2): No readily ascertainable FMV unless among other things

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the option is exercisable immediately by the optionee AND it is NOT subject to a condition/restriction that will affect its FMV.

2. NOTE: §83’s Non-ascertainable FMV restriction ONLY applies to OPTIONS – it does NOT apply to stock.

k. (1) Incentive Stock Options (ISO) must comply with the rules of §421-422, which are very restrictive so it is rarely used. If conditions are met then only the exercise of the option will be a taxable event with gains taxed as long-term capital gains.i. (2) Non-Qualified Stock Options are much more

common and consist of any options that do NOT meet the ISO requirements.

ii. Per IRS regulations non-qualified options do NOT have readily ascertainable fair market values so they are NOT taxable upon grant. However, the exercise is a taxable event and the STOCK will be the §83 property.

1. The non-ascertainable fair market value restriction will NOT apply to the stock.

iii. Non-Qualified Stock Options: FMV – exercise price = ordinary income. [Ex. Price $10, FMV = $70 $60/share of ordinary income, Basis will be $70 ($10 paid plus $60 taxed)]. Upon sale capital gains/losses will be based off the $70 basis.

iv. (3) Equity – Stock Itself: “Restricted Stock” – subject to a substantial risk of forfeiture opportunity to consider filing a §83(b) election – no carve out exclusion even if the FMV is NOT readily ascertainable.

l. §6662: Imposition of Accuracy-Related Penalty – If section applies then 20% of understatement can be tacked on as a penalty.i. (b) Negligence or disregard of rules/regulations

or substantial understatement of income tax.1. (d) Understatement if tax paid is understated

by the greater of 10% of tax due OR $5,000.ii. Important for Tax Lawyers to express to clients

various levels of uncertainties.1. “Reasonable Basis” (15-30%)2. “Substantial Authority” (30-50%)3. “More likely than not” (50%+)4. “Should” prevail (70%+)

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iii. §6662(d)(2)(B) – If taxpayer has “substantial authority” for position then the underpayment penalty can be avoided.

1. Also can avoid penalty if relevant facts are attached to the return and the taxpayer has a “reasonable basis” for the position taken.

2. BUT if you use a “tax shelter” you have to reasonably believe that you were “more likely than not” following the proper treatment.

a. Tax shelter – any plan or arrangement where a significant purpose is the avoidance of federal income taxes.i. Written broadly enough that almost

any activity (ex. buying tax exempt bonds or a house to deduct interest) can be seen as having a purpose of avoidance, but in practice it amounts to a kind of prosecutorial discretion. Unlikely to be used in most cases.

iv. §6664(c) – No penalty under §6662 if taxpayer can show a reasonable cause for a position or acted in good faith with respect to such position.

1. Major factor here is professional advice from a tax advisor.

m. §1041: Transfer of Property Between Spouses Incident to Divorce – No gain or loss shall be recognized and there will be a transferred basis.i. Davis (1962) – H transferred appreciated stock to

W as part of a divorce settlement. SCOTUS holds that W had legal rights by virtue of the marriage and extinguished those claims. Thus this was the use of appreciated property to satisfy a debt so taxable to H (akin to selling $10,000 worth of stock with a $1,000 basis then paying the $10,000 to a third party $9,000 of gain subject to tax).

1. NOTE: Davis was decided BEFORE §1041.2. §1041 has NO application to same-sex couples.

Thus Davis would be the starting point.ii. Rather than attempt to value legal obligations,

the FMV of the obligation will be presumed equal to the value of the property transferred since it is an arm’s length transaction. Technically the amount realized is what he is getting NOT what he is giving up (however, the amount given up is

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being used to get at the value of what is received).

iii. Under §1041 there is a transferred basis in the property (even if it is a loss property). Thus taxpayers should all else being equal transfer the property that they have the lowest basis in order to “pass the buck” in terms of tax liability to the recipient.

n. Farid-Es-Sultaneh (1947) Appreciated stock transferred to W as part of a pre-nup. §1041 does NOT apply. Court held the property was acquired by purchase NOT by gift with the purchase price being the waiver of legal claims in the event of divorce.i. Thus initially H should have been subject to tax

based on the FMV at time of transfer – basis. THEN W should have been subject to tax at the time of sale based on Sale price – basis (FMV at time of transfer).

1. Court does not, but should have addressed W’s basis in her legal rights to determine her initial tax liability. The starting point should probably be $0 since the legal rights sold were not purchased, but it could be argued that certain costs should be factored in (ex. cost of gym memberships, wedding-related expenses, etc.).

2. NOTE: The $800,000 FMV of the legal claim (based on the assumption that it equals the FMV of the transferred stock) ONLY reveals the FMV, BUT that is NOT the basis.

o. §71: Alimony and Separate Maintenance Paymentsi. Alimony is deductible by the payor (above the

line) and taxable for the payee.1. Only cash payments are considered to be

alimony.ii. Child support is NEITHER deductible by the payor

NOR taxable for the payee. 1. Diez-Arguelle (1984) – Back child-support

cannot be deducted under §166 as a non-business bad debt because the taxpayer has no basis in the property. The court specifically rejected the argument that money spent to care for kids created a basis.

III. Personal Deductions and the Alternative Minimum Taxa. “Personal deductions” is shorthand for deductions that

are unrelated to the cost of producing income.

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i. Most personal deductions are “itemized” or below the line deductions, which means they are taken in lieu of the standard deduction and subtracted from AGI to determine taxable income.

1. Above the line deductions are available even if you take the standard deduction, but with below the line deductions you must make a choice between the itemized deductions or the standard deduction.

2. About 70% of taxpayers take the standard deduction.

ii. Gross Income (§61) MINUS Above the Line Deductions (§62(a)) EQUALS -- Adjusted Gross Income (§62) -- MINUS Below the line Deductions (i.e., EITHER the standard deduction (§63(c)) OR Itemized deductions (§63(d))) AND Deductions for Personal Exemptions (§151) EQUALS Taxable Income (§63). [PAGE 353]

iii. Typically taxpayers will only elect to itemize their deductions if the aggregate amount of those deductions exceeds the amount of the standard deduction.

1. The standard deduction along with personal exemptions creates an effective “zero bracket” amount for taxpayers.

iv. §262 – No deductions for personal/family expenses UNLESS expressly provided in this chapter.

v. EXCEPTIONS (Below the line deductions)[Most Common Ones]

1. Casualty Losses - §165(c)(3) Estimated cost of $300M/year.

2. Medical Expenses - §213 Estimated cost of $8.9B/year.

3. Charitable Contributions - §170 Estimated cost of $36.2B/year.

4. Home Mortgage Interest - §163(h) Estimated cost of $82.6B/year.

5. State and Local Taxes - §164 Estimated cost of $62.4B/year.

vi. Employees can deduct business expenses under §162(a), BUT it is below the line AND subject to a 2% floor imposed by §67 [first 2% is non-deductible even after floor is cleared: i.e., on a $100,000 income if $2,001 in expenses then only $1 can be deducted.]

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vii. Deductions will have a greater impact on those in higher tax brackets so it is a differential subsidy based upon marginal tax rate.

b. Casualty loss deductions under §165(c) are limited to (1) losses in trade or business, (2) losses associated with transactions entered into for profit, (3) unless it arises from “fire, storm, shipwreck, other casualty, or from theft.”i. Issue becomes what is “other casualty?”ii. Dyer (1961) Taxpayer claimed a deduction under

§165(c) for a vase destroyed by her cat when the cat had a fit. Tax court rejected this position based on ejusdem generis because “other casualty” should be something similar to fire, storm, or shipwrecks, and cat fits do NOT fit that bill.

iii. §165(h) imposes a $100 minimum claim per casualty, and all claims in the aggregate must exceed 10% of AGI to be deductible in order to avoid de minimis claims.

c. §213 allows deductions for medical expenses above a floor of 7.5% of AGI.i. §213(d) defines medical care as for the

“diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.”

1. Tangentially relevant to medical issues are NOT deductible.

a. Ex. hiring a gardener because taxpayer has allergies.

b. Ex. playing golf because psychiatrist told taxpayer to “relax.”

2. IRS puts out a publication (509), which summarizes the law of deductible medical expenses.

ii. §213(d)(9) Excludes cosmetic surgery unless it is “necessary to ameliorate a deformity arising from … a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease.”

iii. HYPO: Year 1: AGI: $100,000, Qualifying Medical Expenses of $20,000. Floor (7.5%) or $7,500 Deduct $12,500.

1. Year 2: Recovery of $20,000 paid – tax consequences? At most $12,500 will be taxed as income per the Tax Benefit Rule [Could have none of it taxed if provided by another

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section – Ex. if it came in a non-taxable personal injury recovery].

d. §170 Charitable Contributions.i. §170(c) defines charitable contributions.

1. Cash then deduction will be equal to the amount of cash donated.

2. Property – deduction will equal the FMV of the property.

a. HUGE loophole because it allows taxpayers to avoid taxes on items with low basis. Avoids recognition of the built in gain.i. NOTE: If you have loss property

(ex. ADBE stock with a $40,000 basis and a FMV of $6,000) it would lose its built in loss if you donate it to charity. Thus better course is to sell the stock, recognize the loss, and then donate the cash.

ii. Limitation imposed by §170(e)(1)(A): If you sold the property that you are donating and it would give rise to something OTHER THAN long-term capital gains (aka short term capital gains or ordinary income) THEN you can only deduct your basis in the property.

1. Take home advice is donate capital assets that you have held for more than a year so they will get the long term capital gains treatment.

2. §170(e)(1)(B): Donating tangible personal property the gain that would have been long term capital gain if the property was sold at its FMV will be reduced to the basis UNLESS the use of the property by the organization is related to its charitable purpose [primarily serves to make sure that artwork is donated to museums].

ii. Since charitable deductions are an itemized deduction they only confer benefits on itemizers.

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iii. Services that taxpayers donate are NOT tax deductible.

iv. If you get anything back for your contribution you need to deduct the FMV of the item you receive back.

1. Ex. $100 donation, $7 shirt only $93 will be deductible.

v. §170(c)(2)(D) – NO deduction for contributions if the organization engages in political activities that are prohibited under §501(c)(3).

e. Lary (1986) – Taxpayer donated blood then attempted to claim a charitable deduction for the FMV of the blood. Unclear if this was a service (non-deductible) or property, but if property it MAY be deductible.i. §170(e) – If a sale will give rise to ordinary

income or short-term capital gain then you can only deduct your basis in the property.

1. Unclear if this is capital asset under §1221, but even IF a capital asset the holding period is less than one year (based on scientific evidence about blood) so it would be subject to short-term capital gains taxes.

a. Thus only deductible up to its basis, but taxpayer has no basis in the blood so NO deduction.

2. Never reached the question of IF the blood was property.

f. §170(l) - Only 80% of regular deduction will be allowed if donating to a university and by reason of the donation the donor will have the opportunity to purchase seats at athletic events.

g. §163(h) Deduction for home mortgage interest, which is a specific carve out from the general rule that personal interest is NOT deductible.i. §163(h)(3) - Defines qualified residence interest

as Acquisition Indebtedness AND Home Equity Indebtedness.

1. §163(h)(3)(B)(ii) – The aggregate amount treated as Acquisition Indebtedness shall NOT exceed $1M.

a. Marriage penalty issue because if married and filing separately the limit is lowered to $500k, BUT single people get a $1M limit, and 2 single people living together could aggregate a $2M exception.

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2. §163(h)(3)(c) – Home Equity Indebtedness can add on an additional $100k.

ii. §163(h)(C) – Home Equity Indebtedness can be any indebtedness secured by a principal residence, BUT cannot exceed the taxpayer’s equity in the house.

1. No limits on how the funds are used.iii. §163(h)(4) – Qualified Residence is a principal

residence AND one other residence of the taxpayer. h. §164 – Deductibility of state and local taxes (SALT).

It applies to (1) real property taxes, (2) personal property taxes, and (3) state/local income taxes.i. This excludes sales tax, BUT under §164(b)(5)

sales taxes can be deducted in lieu of state/local income taxes at the election of the taxpayer.

1. §165(b)(5)(H): Tables are provided where a taxpayer with x income in y state can take z deduction without having to produce any receipts.

ii. §164 is a regressive subsidy that encourages states to adopt more progressive tax systems than they otherwise might adopt.

i. ALTERNATIVE MINIMUM TAX (AMT) –Basic effect is a parallel tax system in §55-57 with a different rate structure and a different base (flatter rate structure of 26% or 28%, and a large exemption amount, BUT a much broader base post-exemption).i. Exemption amount is set by default to be $45,000

and every year Congress passes a patch, which changes that threshold in §55(d)(1)(A); however, the law is written without automatic adjustments for inflation so the change requires an affirmative act by Congress.

ii. AMT rules apply to EVERYONE who must calculate AMT tax liability AND regular tax liability then pay the higher of the two.

1. Thus it applies when the AMT tax is higher than the regular income tax.

2. If someone is subject to the AMT then cutting their regular taxes without cutting AMT taxes will be useless because they will be subject to the HIGHER of the two.

iii. Klassan (1999) – Taxpayer with 10 kids and an AGI of $83,056 challenged AMT tax liability NOT mechanically, BUT on the grounds that Congress only intended to hit wealthy individuals with the AMT.

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1. 10th Circuit held that the statute is crystal clear and the AMT applies.

2. Reasons taxpayer faced more AMT than regular tax liability.

a. NO personal exemptions under the AMT.b. NO SALT exemptions.c. Medical expense floor raised from 7.5%

of AGI to 10%.i. NOTE: Charitable contribution and

home mortgage interest deductions are unaffected under the AMT.

IV. Allowances for Mixed Business and Personal Outlaysa. Conflict between §162(a), which generally allows

deductions for ordinary/necessary business expenses AND §262, which generally prohibits deductions for personal living/family expenses.i. Creates a line drawing problem in places where

these two provisions intersect. b. §62(a)(2)(A) – If an EMPLOYEE bears a business expense

that is reimbursed by the employer than it is deductible above the line (in practice it is merely ignored because there would be income of x followed by a corresponding deduction of x for a net gain of 0).i. Non-reimbursed employee business expenses are

below the line deductions.1. §67 – Individual miscellaneous itemized

deductions, which consist primarily of unreimbursed employee business expenses, has a 2% floor.

a. Ex. $100,000 AGI then first $2,000 is NOT deductible.

2. Miscellaneous business expenses under §67(b) are NOT deductible under the AMT per §56(b)(1)(A)(i).

c. Home Office Deduction: §280A(a) – Generally there is no business deduction if it is a dwelling unit and the taxpayer uses it as a residence.i. §280A(c) does allow a deduction if the space is

EXCLUSIVELY used on a regular basis as the principal place of business for any trade or business of the taxpayer.

ii. Popov (2001) – Concert violinist who lived in a one-bedroom apartment with husband and daughter claimed the living room was her home office that she used to practice her music.

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1. Only deductible if it is her principal place of business per §280A(c) – the court used the Soliman Test:

a. (1) Relative Importance – No one factor is determinative, but SCOTUS gives great weight to where goods/services are delivered.i. Court held that the service

delivery model did NOT work well in the context of music so found this to be inconclusive (between concert halls for performances and the apartment for practice).

b. Amount of Time – Taxpayer spent FAR more time practicing than performing.i. Thus the court found the deduction

to be proper. iii. The Service takes the position that §280A(a)’s

general rule takes precedence over §280A(c) when in doubt.

1. Essentially it argues that §280A(c) is a minor exception to the general rule.

d. CHILD CARE DEDUCTIONS - Smith (1940) – Taxpayer argues that childcare expenses should be deductible because “but for” them the wife would NOT be able to work thus it was a cost of producing income. The court rejected the argument because it knows no bounds and would turn EVERYTHING into a business expense. i. It held that childcare was a PERSONAL expense,

which is a long-standing position in American tax law.

ii. This case arose pre §21 and §129.e. §21 – Child Care Tax Credit: 35-20% of expenses spent

on childcare (the % drops as one’s AGI goes up).i. §21(b)(2)(A) - The expense has to be employment

related in that it allows the taxpayer to work.ii. §21(a)(2) - 20% rate kicks in at an AGI of

$45,000.iii. §21(c) – Employment related expenses that can be

multiplied by the % shall NOT exceed $3,000 for 1 kid OR $6,000 for 2 or more kids.

iv. This is a non-refundable tax credit – so NOT helpful for those with 0 tax liability.

1. Credits come AFTER tax liability is calculated then they serve as a dollar for dollar reduction in tax liability.

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v. You cannot take both §21 and §129 – have to choose one or the other.

f. §129 – Dependent Care Exclusion – Maximum of $5,000 of income can be set aside from otherwise taxable salary and not be taxed provided that it is spent on qualifying dependent care related expenses.

g. §24 – Child Tax Credit - $1,000 value for a kid, but it has various phase-outs as AGI goes up.

h. BUSINESS TRAVEL EXPENSES - §162(a)(2) –Deduction for traveling expenses, which are NOT lavish while away from home in the pursuit of a trade or business.i. Flush language – Must be for 1 year or less.ii. Flowers (1945) – Taxpayer lives in Jackson,

Mississippi and his office is in Mobile, Alabama. SCOTUS created a 3-part test to determine if the travel expenses were deductible under §162(a)(2): (1) Expenses are reasonable and necessary, (2) incurred while away from home, AND (3) in the pursuit of a trade or business.

1. Court held these were NOT business expenses.2. Case has come to be seen as a COMMUTING

EXPENSES case which is NOT deductible either because (3) it is not incurred in the pursuit of a trade or business OR (2) was NOT incurred while away from home.

iii. The Service sees “home” as the principal place of business rather than one’s personal residence.

1. Thus one who works out of one office (ex. LA) and then travels to another office (ex. Boston) will be away from home and able to deduct his travel expenses under §162(a)(2).

iv. Hantzis (1981) Law student from Boston took a summer job in NYC. She deducted her travel and lodging expenses to/in NYC under §162(a)(2). The 1st Circuit rejected the deductions because it held that the taxpayer’s home (aka principal place of business) was in NYC thus those expenses were NOT deductible AND her trips to Boston were for PERSONAL reasons so that also was NOT deductible.

1. Temporary away from home expenses can be deducted even though things like rent/food would typically be a non-deductible personal expense, BUT one has to be away from his tax home in pursuit of a trade or business.

a. Ex. Law professors teaching at a different school away from their tax home over the summer.

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b. The connection has to be to the taxpayer’s trade or business (i.e., as a law professor), BUT does NOT need to be for the convenience of the “home” employer.

c. Temporary employment expenses can be repetitive as long as each is “temporary.” Two part test: (1) subjective – intent of the taxpayer is to return to the permanent home within the year, and (2) objective – it has not been more than a year.

i. CLOTHING EXPENSES: Pevsner (1980) Taxpayer worked at a YSL boutique and had to buy YSL clothes to wear to work. The taxpayer deducted the clothes as a business expense and the IRS challenged that position. In order to be deductible clothing must be:i. (1) of a type specifically required as a

condition of employment,ii. (2) NOT adaptable to general usage as ordinary

clothing, ANDiii. (3) NOT so worn by the taxpayer.iv. The court held the clothes were NOT a deductible

expense because #2 is objective and the clothes were adaptable even though the taxpayer only used them for work.

v. Uniforms in general are deductible because they pass the objective test under #2, but this rarely comes up because of the 2% floor imposed by §67.

j. Gilmore (1963) H attempts to deduct legal bills from his divorce proceeding where he was resisting W’s claim of ownership in his 3 GM dealerships.i. H claimed the deduction under §212(2) as an

ordinary and necessary expense for the “management, conservation, or maintenance of property held for production of income.”

1. NOTE: This provision is similar to §162 deductible business expenses, but it is more lax in that the activity does NOT have to rise to the level of a trade or business.

ii. SCOTUS rejected the deduction stating that the “ORIGIN of the CLAIM” must be business based in order for the deduction to apply.

1. In this case the origin was personal even though it ultimately would have impacted the income producing property.

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iii. NOTE: Even though the underlying litigation cannot be deducted (i.e., the divorce litigation expenses). The tax litigation expenses CAN BE DEDUCTED under §212(3), which allows for the deduction of expenses “in connection with the determination, collection, or refund of any tax.”

V. Business Expenses, Appreciation/Amortization, and Tax Sheltersa. Depreciation is based on the idea that there should be

an offset against revenues for the cost of “wasting” assets that are used for the production of those revenues, but has a life extending beyond the current tax year.i. Deductions for deprecation, or cost recovery,

results for tax purposes in a reduction in the basis of an asset.

ii. Specifics about depreciation deductions are laid out in §167-168.

iii. Prior to 1981 you needed to know: (1) Useful life of item, (2) Salvage value [could deduct amount paid – salvage value], and (3) Allocation methodology.

1. 1981 Tax Reform Bill – Accelerated Cost Recovery System (ACRS) defined useful lives for categories of assets, ignored salvage values, and allowed accelerated allocation methods that front-loaded deductions.

b. What are the tax implications of the sale of property?i. Amount realized AND Adjusted basis per §1001.

1. Adjusted Basis HYPO 1: Blackacre purchased for $100,000 cash.

a. §1012 cost-basis is $100,000.2. Adjusted Basis HYPO 2: Blackacre purchased

for $100,000 using a RECOURSE loan.a. §1012 cost-basis is $100,000.

3. Adjusted Basis HYPO 3: Blackacre purchased for $100,000 using a NON-RECOURSE loan.

a. §1012 cost-basis is $100,000 per Crane and Tufts.

c. Amount realized is the stuff coming to the person who is selling. It does NOT have to be cash. If could be for example:i. Cashii. Propertyiii. Assumption of Recourse Liability

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d. Crane (1947) when selling property the value of any Non-Recourse debt assumed by the buyer needs to be factored into the amount realized by the seller.i. When buying the property the adjusted basis will

be the amount paid for the property, which includes the proceeds from loans (recourse or not) that are used to pay the seller.

ii. Tufts (1983) Crane’s factor Non-Recourse Debt assumptions into amount realized rule applies even if the taxpayer has no equity in the property.

1. With Non-Recourse debt there CANNOT be CoD income, BUT the sale of property will recognize the debt as part of the amount realized.

2. With Recourse loans if property is used to satisfy a debt then 1) if the FMV of the property is less then the debt there will be CoD income, and 2) gain/loss will have to be recognized on the property sold to satisfy the debt.

e. TAX SHELTERS – Taxpayers bought properties to take advantage of ACRS depreciation deductions to offset ordinary income, which allowed them to 1) defer taxes and 2) convert ordinary income into capital income.i. The 1986 Tax Reform Act took away much of the

benefits of tax shelters:1. §465 – At Risk Rules: Only can take losses on

investment to the extent that you have an investment at risk.

a. Ex. $100k down and a NON-RECOURSE loan then can only take depreciation deductions up to $100k.

b. At risk = cash, property, proceeds from any recourse loan, OR Non-Recourse loans from a bank.

2. §469 – Passive investors can only deduct passive losses against passive income. Thus cannot be used to shield ordinary income.

VI. Assignment of Income, the Marriage Penalty/Bonus, and the EITCa. Lucas v. Earl (1930) Taxpayer had a contract with his

wife to split his income 50/50. Purpose of the contract was to get “two starts at the bottom” for the progressive marginal tax rates. SCOTUS held that H as the earner should be taxed on all the income and he could NOT assign ½ of the liability to W by contract.

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i. Holding applied to common law, non-community property states.

b. Poe v. Seaborn (1930) – Same facts as Earl except that the 50/50 split came via state Community property law NOT a private contract. SCOTUS held that even though only H was working they were allowed 2 starts from the bottom of the rate structure because each was entitled by law to a ½ share of the community’s income.i. Holding applied to Community Property States.

c. In 1948 Congress responded by changing the rule so everyone can get the benefit of Poe v. Seaborn by creating the “married filing jointly” status.

d. This created a “singles penalty” because a single tax payer only gets one start from the bottom, but the same taxpayer will get two starts from the bottom once he gets married.

e. Marriage bonus = single’s penalty and vica verse.f. In 1969, Congress created a modified rate structure

that reduced but did NOT totally eliminate the single’s penalty.i. It also created a marriage penalty for some

earners.ii. Goal was fundamental COUPLE EQUALITY so couples

earning equal amounts would face the same tax liability.

1. Disparate income earning couples usually get a Bonus, via two starts from the bottom.

2. Couples with fairly even split earning power usually have a Penalty because in the higher brackets the breakpoints for married couples are less than 2x that for singles.

a. Only the 10% and 15% tax brackets have the exact same breakpoint of 2x the single rate.

iii. Three fundamental and irreconcilable values:1. Couple equality – equal earning couples

should have the same tax liability.2. Marginal rate progressivity.3. Marital status neutrality.

g. Gay people married under state law are single for tax purposes per the Defense of Marriage Act (DOMA).i. Bush era IRS Chief Counsel Memo held that Poe v.

Seaborn only applied for marriage so tax has to be paid entirely by the earner and cannot be split between a couple.

ii. 2010 Chief Counsel memo held that Poe v. Seaborn applies so gay couples who have equal rights to

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income under state CP law get 2 starts from the bottom and must each report ½ of the community income.

1. NOTE: this will trigger an automatic audit when only ½ of W-2 income is reported on a tax return.

h. Earned Income Tax Credit (EITC) is the principal income transfer program for low-income households in the US today.i. This is a wage subsidy, which creates a negative

marginal tax rate via a refundable credit. The more one makes the more they will get back – up to a point.

ii. Once the threshold point is crossed (varies based on marital status and number of kids) the credit will be phased out, which is the same as saying tax liability is going up.

iii. Depending on the specific facts (ex. income and number of kids) the EITC can confer either a marriage penalty or bonus.

VII. Capital Gains and Losses a. Capital gain is gain from the sale of a capital asset.b. §1221 defines capital assets as property held by the

taxpayer.i. Specific exemptions include amongst other things:

inventory, real property used in a trade or business, and copyrights, which the taxpayer produced via labor [ex. wrote the book].

c. §1(h) the maximum statutory rate for capital gains is 15%, which is applied to the NET CAPITAL GAIN.i. Net Capital Gain = [Net of Long Term Capital Gains

over Long Term Capital Losses] – [Net of Short Term Capital Gains – Short Term Capital Losses].

1. Long term comes from the sale of capital assets that were held for one year or over.

2. Short term comes from the sale of capital assets that were held for less than one year.

d. Net capital losses can only offset up to $3,000 of ordinary income per year, but excess losses that are NOT used can be carried forward to subsequent tax years.

e. If a transaction is characterized as the sale of a capital asset then it will be subject to the favorable capital gains tax rate AND the basis of the property can be deducted from the sale price.

f. Womack v. Commissioner (2007) Court held that based on the substitute for ordinary income doctrine when a

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party receives a lump sum payment as a substitute for what would have otherwise been received at a future time, as ordinary income then the lump sum will be taxable as ordinary income as well.i. Thus the court held that the right to receive

lottery winnings was NOT a capital asset within the meaning of §1221 because the proceeds are taxed as ordinary income.

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