Federal Income Tax (Spring 2005) Alstott Short Outline Fringe Benefits (Assignment 3 § 61, 105, 106, 119, 132
) Benaglia p. 125 (Fringe benefits, ―convenience of the employer‖ test; Hawaiian hotel case Code: §§ 61; predecessor to § 119 Holding: An exception to the general principle that fringe benefits are includable for taxation purposes. Held that the meals and lodging were for the ―convenience of the employer,‖ and not for the employee’s personal consumption. Issues: Efficiency concerns (incentive to create live-in jobs), Valuation problem (court picks all-or-nothing approach to business/personal distinction, although such solutions exist in 274(n)). Gotcher p. 120 (Fringe benefits, ―dominant business purpose‖ test; VW case) Code: § 61 and 119 Holding: Court uses a dominant business purpose test to determine whether the expense is personal or business, and taxes accordingly. Trip is excludible to husband, taxable to the husband as a gift to the wife. Issues: Horizontal equity (similar individuals treated differently because of business perks), Vertical equity (more affluent people are better positioned to take advantage of these perks). § 61 is read quite narrowly here. Kowalski p. 126 (Fringe benefits, meals, narrow reading of § 119; state trooper case) Code: § 119 Holding: Cash meal allowance was income; § 119 applies only to meals eaten on premises for convenience of the employer. Issues: Concern about income substitution (paying people in meal allowances, for example), Valuation problem (how much does the trooper value this good). § 132 (Fringe benefits) Discrimination clause (j): Must be equally available to all employees No-additional cost fringes (a1) (also offered for sale to customers, employer incurs no additional cost to do so). Qualified Employee Discount (a2) (up to 20% off regularly offered services) Working Condition (a3) (any property or service provided that would otherwise be excludable under § 162) De Minimis (a4) (―so small as to make accounting for it unreasonable or administratively impracticable‖) Transportation (a5) (transit passes, limited parking) Spouses and children (h2) – generally treated as the ―employee‖ Gyms (j4) – generally excludable.
Form of Receipt (Assignment 2 § 61) Old Colony Trust p. 98 (Substance over form, payment of other’s debts; Woolen executive tax case) Code: § 61 Holding: When a third party pays expenses, it’s an accretion to net worth, and form doesn’t matter. This was not a gift, since there was no charitable impulse. Tax Expenditures (Assignment 4 § 32 163(h) Surry and Tax Expenditure Significant tax expenditures: § 105 and 106 (health insurance), Mortgage deduction, dividends and capital gains rates. Gifts and Bequests (Assignment 5 § 102, 117, 274(b)) Duberstein p. 133 (business gifts, detached and disinterested generosity; Cadillac case) Code: § 102 and 274(b) Holding: Gifts are not deductible for donor, but excludable to recipient. Gifts are determined by whether the donor had ―detached and disinterested generosity‖, or whether there was some expectation of continuing profitable relations. Cf. Stanton. Issues: o Business gifts are barred by statute (§ 102(c) for employer-to-employee and § 274(b)). Some will still be treated as ―de minimis‖ or ―working condition‖ fringes under § 132, however. o Current law is designed to prevent income shifting, which would occur if we allowed deduction for the donor and inclusion to the recipient (and presumed that donors were generally in higher income categories than recipients). Basis Recovery (Assignment 6 see below + § 1041) § 1012: Basis = cost of the property. § 1001: Gain = Amount realized – basis ; Loss = Basis – amount realized. § 1015: Gifts. No basis in cash, carryover basis to the donee (allows income shifting). However, if property depreciates in the hands of donor (§ 1015(a)) and donor sells at a loss, the basis is stepped down to FMV, no loss allowed to donor (the loss basis rule). § 1014: Bequests. Basis is FMV at death, allowing for a step-up or step-down basis. Leads to lock-in by elderly who hold to death rather than sell at a gain. Hort p. 151 (Income, cancellation of debt income, what has basis; building lease/sale case) Code: § 61(a)(5) (rents); now § 167(c)(2) (property basis can’t be attributed to a lease; unless only the lease was purchased, which creates a basis = to amount paid).
Holding: A substitution for income is income itself – here, the $140k was prepaid rent that P used to forego the $161k lease. A lease does not have basis – only the building has basis. Issue: P wanted to accelerate his deductions and defer his income, which is why he wanted to get the basis recovery in the lease immediately.
Farid-Es-Sultanah p. 484 (Step-up basis, carryover basis, gifts; Prenup case) Code: § 1041 Holding: When a person receives property in return for surrendering marriage rights, the transfer is a ―sale or exchange‖ and not a gift. This allows P to use the much higher ―basis at point of sale‖ rather than the much lower carryover basis. Dissent: This should be a gift – P could have kept the stock had K died pre-marriage and the agreement, and would therefore not have given up anything. Issues: A familial exchange is treated like a commercial transaction. § 1041 now says there is carryover basis for divorce settlements, but FES is still good law for cohabitants – transfers will be treated like sales/exchanges, not gifts. The Realization Requirement (Assignment 7 § 1001) Problems with Realization 1. It is arbitrary 2. The doctrine is justified in the name of liquidity and valuation, but Eisner indicates that it doesn’t account for those principles very well. Treated real gain as zero b/c still tied up in company. 3. Creates inefficiencies because it encourages people to engage in complex tax planning and transaction they otherwise would not engage in 4. Lock-in – because transactions drive the tax, people will hold onto assets longer than they otherwise would 5. Higher tax rates to compensate for the smaller tax base 6. Postpones taxation because deferral is valuable 7. Inequity: it permits tax shelters to exist by those wealthy enough to afford them. Horizontal as well b/c depending on what you invest in – (stocks v. house) you are treated differently 8. Drives the capital gains rates Cesarini p. 156 (Windfall gains, treasure trove, prizes; cash in the piano case) Code: § 61, 74 Holding: Windfalls are income under § 61, as broadly construed – they’re not gifts under § 102, or prizes under § 74. Windfall is taxed at the time it was ―reduced to undisputed possession.‖ Issues: Windfalls are taxed in order to allow for taxation of gambling gains, and to prevent expanding the gift category. Treasure trove need not be cash, but does not include imputed income of valuable goods/services you create yourself (like paintings). Haverly p. 159 (Charitable donations, double-deductions; school principal books case) Code: § 170 3
Holding: Donation of unsolicited samples is a realization event, and is counted as income if donor claims a charitable deduction. It’s ok to just keep the books without including them in income, however, under Benaglia as a fringe. Even though not employer giving benefit Cottage Savings p. 166 (realization, ―materially different‖ standard; mortgage swap case) Code: § 1001 Holding: If the exchanged properties are ―materially different‖, they create a realization event if they ―embody legally distinct entitlements.‖ Even though the mortgage pools were ―substantially identical‖ for bank purposes, they are different enough for tax purposes to trigger a realization event (and a loss for P). Issues: This is an extremely form-over-substance transaction. No valuation or liquidity problems here; compare to Eisner (where P couldn’t be forced to realize). Eisner p. 161 (realization, stock dividends; XVI Amend. case) Code: XVI Amend; §61(a)(7) on taxing dividends; now § 305 codifies result. Holding: Stock dividends are not a realization event, and are not taxable. A stock dividend postpones realization, and there is a liquidity concern (forcing people to pay taxes on an asset that isn’t liquid). Issues: Illustrates arbitrary differences between cash dividends (taxed on receipt), retained earnings (not taxed) and stock dividends (taxed on sale). Valuation and liquidity concerns were they key to the decision. Borrowing (Assignment 8 § 61(a)(12), 108) Collins p. 180 (―no mutual understanding‖, ―no bona fide intent to repay‖; stolen betting slips case) Code: § 61, § 165(c) (for repayments of losses). Holding: Unlawfully acquired income is still taxable (James); it’s not a loan. Court says there was ―no mutual understanding‖ about repayment between P and employer, and that (unlike in Gilbert), there was no ―bona fide intent to repay‖ (cf. bona fide businesses, where there is at least an attempt to make money, even if there is an eventual loss). Issues: There is deduction when P repays the stolen money (§ 165). P’s amount ―lost‖ is considered a consumption ―gain‖. Zarin p. 197 (Cancellation of Debt income, gambling losses, basketing; Casino overdraft case). Code: § 165(d) Holding (District Court): The difference between your credit and your repayment, if forgiven, is ―cancellation of indebtedness‖ income, which is taxable. This is not a gift, since there’s no ―detached and disinterested generosity‖ on the part of the casino. Holding (Third Circuit): Overturns lower court on grounds that the loan was unenforceable under NJ law. Issues: Note that P cannot count his COI ―gain‖ against his gambling losses, since § 165(d) baskets gambling losses, and allows them only to be offset against one another. § 108 (COI) – See also Kirby Lumber (discharge of indebtedness is income)
Bankruptcy: Taxpayer can exclude some/all COI income if the taxpayer is bankrupt (a1B) Purchase price adjustment: If debt of a purchaser to a seller is reduced, it’s a purchase price adjustment rather than cancellation of indebtedness (i.e., the case when the buyer asks for a reduction in a building price because of asbestos removal costs). (e5)
Basis and Borrowing (Assignment 9 § 465 and 469 ) Crane p. 199 (Recourse and Nonrecourse Debt, depreciation, basis; mortgage building sale) Code: predecessor to § 1014 Holding: Nonrecourse debt is treated exactly the same as recourse debt for tax purposes. If you take depreciation deductions (and depreciation is mandatory), you need to ―pay‖ for them with real money at some point. Tufts p. 200 (Recourse/Nonrecourse, lower than FMV depreciation, tax shelter; opposite of Crane) Code: § 1001, 1012 Holding: Nonrecourse debt is included in basis and amount realized even if the debt exceeds the FMV of the property. There needs to be a symmetry between recourse and nonrecourse, as well as for gain/losses. Court doesn’t want to overturn Crane. Issues: Although P is truthful when he says he’d never pay the NRD if the property is underwater, to not include it in income would give him depreciation deductions on the erroneous presumption that he’d paid for the building out of after-tax income. Court continues a fiction. Note: The tax shelter trick was to get ordinary depreciation losses, and capital gains from the sale – this is conversion. Debt and Tax Shelters Estate of Franklin p. 209 (Nonrecourse, seller-financing, overvaluation sham, tax shelter, conversion). Code: § 167(a); 1001, 1012 Holding: Gross overvaluation of a property for the purpose of acquiring depreciation deductions via the use of nonrecourse debt and seller financing is illegal, particularly with an installment sale (where taxes are paid only when the principal comes in). There was no ―economic substance‖ in this deal – no investment risk on the part of P, and no genuine debt against which to deduct interest. Issues: This case arises because Crane said NRD and recourse are both to be treated as ―real‖ debt. Cf. Pleasant Summit, where court allowed depreciation on the amount of the loan equal to the FMV (i.e., genuine debt) only. Responses to Estate of Franklin Shelters Judicial – cases like Franklin, where courts prohibited NRD and seller-financing where there was gross overvaluation. This was too ad hoc, and many taxpayers played the audit lottery. Congressional (applies only to individuals, not corporations)
o At-risk rule (§ 465) – If a transaction involves NRD and SELLER FINANCING for example, no deductions for excess losses. o Passive loss rule (§ 469) – If the taxpayer doesn’t ―materially participate‖, s/he may not deduct losses in excess of gains. Also, ―basketing‖ – losses can only offset income from that activity, and can’t be shifted to cover other activities.
Ordinary and Necessary Business Expenses (Assigneiment 10 § 67, 162, 212) §162 Trade or business expenses (a) In general—deduction allowed for ordinary and necessary expenses from carrying on a trade or business, including: (1) salaries (2) traveling expenses including food and lodging. Cannot be extravagant. (3) rentals (b)(c)(e)(f)(g) no deduction for a various things (often illegal). §212 Code §212 Expenses for production of income Individuals (only) are allowed to deduct ordinary and necessary expenses‖ (1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax. § 67 2% Floor on misc. itemized deductions Itemized deductions allowed only the extent that they exceed 2% of AGI. (b) Exceptions to what counts as itemized deductions like charitable donations and medical expenses. § 212 expenses have to be itemized. (c)Covers unreimbursed business deduction expenses. Welch p. 231(business/personal distinction, ―ordinary and necessary‖, deduction, goodwill. Grain executive case) Code: § 162, 263, 212. Holding: Expenditures made to induce goodwill are not immediately deductible ―ordinary and necessary‖ business expenditures under § 162 or 212. While they may be necessary, they’re not ordinary (court worries about allowing deductions for moral obligations or protecting personal reputation, rather than ―busy-ness‖ business expenses). Welch has to capitalize this goodwill into his business under § 263 (which he reclaims upon sale). Issues: Ordinary means ―normal/useful/customary‖, Necessary means ―helpful and appropriate‖. ―Life in all its fullness‖ provides the test.
Gilliam p. 234 (Origin of the claim test, litigation expenses, ordinary business expenses. Airplane case) Code: § 162 Holding: Introduces the ―origin of the claim‖ test for deciding whether or not litigation expenses can be deducted as § 162 ―ordinary and necessary‖ expenses. Here, the litigation did not arise from the business of being an artist, so no deduction. Issues: o Cf. Dancer, where transport was also necessary for doing the work, but P is allowed to deduct expenses. o The issue seems to be between ―accidents‖ and ―intentional conduct‖. Tellier p. 246 (Origin of the claim, litigation expenses; SEC securities fraud case). Holding: Legal fees were deductible; although IRS argues for a public policy exception (outlined in § 165, which limits deductibility of losses that would ―frustrate sharply defined … policies.‖). Court wants to send the message that it’s acceptable to defend oneself when the charge arose from their line of business, and that it shouldn’t be predicated on ex post vindication. Tank Truck (Fines are not deductible) Holding: Fines paid to government are not deductible; codified in § 162(f). However, damages paid to private parties are deductible unless that payment is ―akin to a fine‖. Salaries (Assignment ) Exacto Spring p. 237 (Salary deductions, independent investor test) Code: § 162, cf. 162(m) Holding: Reasonable salaries are deductible business expenses, and when ―independent investors‖ would be found to be getting a ―reasonable return‖, salaries will be deemed reasonable (and not disguised dividends. Issues: Note that § 162(m)’s limits on salaries over $1m is only for publicly-traded companies, and can be exceeded if there are publicly-disclosed performance standards. Also, there’s a question of ―how do you identify what’s salary and what’s dividend a in a closely-held company?‖ “Business and Investment Expenses” § 162 v. “Personal Expenses” § 262 (Assignment 14) Baselines In the absence of statutory rules, the IRS and courts have traditionally applied several rules to distinguish deductible business/investment expenses from nondeductible personal expenses: a) Primary purpose: disallow deduction unless the taxpayer’s primary purpose in incurring the expense is business. b) Inherently personal: some kinds of expenses are so personal that they can not be considered business expenses even when they are required to work. i) Work clothes (not uniforms) c) Appropriate and helpful: expenditures for items that are both appropriate and helpful to the business are deductible
d) Reasonableness: even if an expense is business-related, it must be reasonable in type and amount. Pevsner p. 261 (Business versus personal expenses; YSL clothes required for employment case) Code: § 162(a), 262 Holding: Test for deducting clothes as business expenses is an objective one: (i) the clothing must be of a type specifically required as a condition of employment, (ii) it can not be adaptable to general usage as ordinary clothing, and (iii) it is not worn as ordinary clothing. Here, P admitted the clothing was adaptable, and loses under § 262. Issues: Compare to Benaglia, where meals and lodging were deductible – yet both were ostensibly ―for the convenience of the employer‖ and clearly got some personal consumption out of it. There’s an upside-down subsidy problem (wealthier people will be able to deduct lots of suits, for example). McCabe p. 269 (Commuting expenses; NJ/NY police officer case) Code: § 162, 262 Holding: Commuting costs arise from a personal choice of the individual as to where to live (see Flowers); just because P was required to carry his gun doesn’t mean that he should deduct expenses for choosing to live somewhere that requires a longer commute. Issues: Cf. Fausner, which allowed deduction for additional expenses required for transporting job-related tools.‖ Essentially, this was a public policy ruling, since it would otherwise shift the tax burden to those who don’t/can’t commute. Hantzis p. 272 (―away from home‖, transport expenses; Harvard-NYC law student case) Code: § 162(a)(2), § 262 Holding: For travel expenses to be deductible, they must be a) necessitated by business, rather than personal demands, b) ordinary and necessary, and c) incurred while away from home. Here, court says § 162(a)(2) was not intended to cover someone who maintains two homes for personal, rather than business, reasons. P had no business connection to Boston, so her home was NYC, and trips were personal. AA thinks logically sound to include her law school as trade or business but tax code generally doesn’t count education as trade or business. “Business/Investment Expenses” § 162 v. “Capital Expenditures” § 263 (Assignment 15) Overview The difference between § 162 and § 263 is timing, not the type of expense! For §263(a) –read ―any property or estate‖ very broadly. o It has to do with any kind of property or endeavor, not just real estate. o Securities and intangible business things are also included under it. Capitalization is the process of taking an expenditure and adding it to basis. It has NOTHING to do with capital gains. Non-deductible (i.e., non-§ 162) capital expenditures are typically the acquisition of business/investment assets that will last longer than one year. Repairs versus Improvements, Advertising 8
Repairs (including asbestos removal) deductible, improvements have to be capitalized. Fixing the sink v. redoing who bathroom. Advertising is deductible as a current expense. Just a quirk. 99 cent hamburger thing
Woodward p. 302 (Deduction versus capitalization, appraisal litigation costs) Code: § 162, 212, 263 Holding: Costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures, and this includes appraisal litigation costs. Court used the “origin of the claim” test, noting that establishing the stock purchase price was clearly part of the acquisition process. Issues: Note that P could try to claim under § 212 because stockholders are individuals. Holding stock is not a ―trade or business‖ (except for stockbrokers). Note also that this is a hard case because litigation expenses feel ―ordinary and necessary.‖ INDOPCO p. 309 (deduction/capitalization; ―lasting benefits‖ test; friendly takeover costs case) Code: § 162, 263 Holding: Takeover expenses must be capitalized, and cannot be deducted as ―ordinary and necessary.‖ The deductions allowed under § 162 are specifically enumerated, this doesn’t fall within those bounds, and the expense will certainly yield a benefit lasting longer than one year (the ―future benefit test‖). Therefore, § 263 applies. Creation or enhancement of a separate asset sufficient but not necessary for capitalized expenditure. Issues: Woodward doesn’t control because there, the taxpayer was buying and here the taxpayer was being bought. PNC Bancorp (deduction/capitalization, lasting benefits) Code: § 162, 263 Holding: The correction to INDOPCO; holds that bank’s loan origination costs are ―ordinary and necessary‖, and can be deducted under § 162. The problem is that everyone knew they were ―ordinary and necessary‖ – the right question was whether, under INDOPCO, the costs created ―lasting benefits‖ (which they probably did). Issue: After INDOPCO everyone thought that lots of previously-deductible expenses were going to be deemed ―capital‖, leading to an IRS field day. PNC stops this, says that common sense ―day-to-day‖ expenses are deductible, but using less-than-ideal reasoning. Capital Recovery: Depreciation (Assignment 13 Code § 167,168, Skim 197, 1245) Simon p. 344 (Wear and tear, determinable useful life, depreciation; violin bow case) Code: § 167, 168 Holding: P can depreciate their bows under § 168’s accelerated cost recovery provisions. The standard for determining whether something is depreciable is now ―wear and tear‖, rather than the stricter standard of ―determinable useful life‖ (which would have rendered the bows un-depreciable). Issues: o P can only take this deduction because the bows were used ―in trade or business‖. Court views § 168 as subsidizing investment and creating a bright-line rule. There’s a concern about valuation in these instances. 9
o Bows are unique in having this dual characteristic of playing (which depreciates) and antiques (which don’t). A bifurcation approach might be best, but we use an all-or-nothing approach instead. IRS said declines to follow in non-2nd Cir. Jurisdictions. Interest (Assignment 14 § 163, 264, 265) Knetsch p. 360 (Interest, tax arbitrage tax shelter, substance over form, indebtedness; annuities shelter) Code: § 23b, 163(a) Holding: Deductions for interest taken for gross interest paid to an insurance company for annuities (i.e., a tax-deferred income stream) using is not ―interest paid on indebtedness‖ under § 163(a), since there was no economic substance in this transaction (i.e., the annuity was never going to pay out, and P would have no reason to do it other than the tax benefits). P paid $50k to get $100 tax savings. Issues: Nonrecourse debt was useful here, but not essential – there’s no ―overvaluation‖. Also, no one lied here – so it’s not fraud. Tax preferred status is what’s doing the work, but that’s Congressional policy. It’s just no economic substance. § 264(a)(2) bars the specific Knetsch transaction by statute (but leaves open the possibility of ―stupid‖ transactions that inadvertently create losses). Also, § 163(d) now requires a ―basketing‖ of investment interest gains/losses. Losses (Assignment 15 § 165) § 165 Generally Denies deductions for personal losses (along with § 262) other than those through theft or casualty, and then only if the loss is above the 10% floor of AGI (§ 162(h)). Plunkett p. 379 (hobby losses, deductions; mud racing / truck pulling case) Code: § 183, also 162 and 212. Holding: No deductions under § 183 if the activity is not for profit – court applies a ninefactor ―profit motive‖ test (p.380). Mud racing fails, because it would never return a gain, but truck pulling succeeds, because P was diligent about it, and had the possibility of winning money. Issues: Under § 183(b), you can deduct up to the amount of your income in a not-forprofit activity from the expenses you incur. So it’s a ―basket‖ approach. Also a valuation problem (separating out business from personal). Fender p. 388 (tax treatment of losses, economic substance, tax shelter; bond resale case) Code: § 165, § 267 (bars related-party sales), 1091 (wash sales); but they don’t apply to non-bona-fide sales like this one. Holding: P cannot use the losses incurred on his sale of the bonds to the bank to offset gains in his son’s trusts, since there was no economic substance to the transaction. In specific, there was ―no exposure to risk” that the bank would not resell the bonds to P after the wash period.
Issue: How does this differ from Cottage Savings? Formally, because here the bonds were literally fungible and identical, whereas properties differed. Note that P actually followed the letter of the law here – raising issue about creating legal ―penumbras‖.
§ 267 Rules Losses are disallowed entirely when there’s an intra-family sale or exchange. However, if the property is later sold at a gain, the gain is offset by the seller’s unrealized loss. For example: Mom’s asset of 10 sold to son for 6; loss of 4 disallowed. Son later sells at 13; his gain of 7 is offset by the previous loss of 4, leaving gain of only 3. Tax Shelter Losses (Assignment 19) Tax Shelters Defined: Investment or transaction that produces a tax savings greater than appropriate given its economic gain or loss (usually passive investments). Usually involves mismatching of deductions and income to produce net losses that offset other unrelated income ( produces tax credits that apply to taxes from unrelated income). Horizontal inequities (people with similar actual incomes pay different amounts in taxes). Vertical inequities (rich typically benefit the most from tax shelters). Five Basic Techniques of Tax Shelters 1. Income shifting (giving deductions to party in higher tax bracket, or giving income to party in lower tax bracket (including sale-leasebacks, like Estate of Franklin) 2. Exemption (receiving tax-free income (interest on state and local bonds, IRAs)) 3. Tax deferral (investment that provides deductions right away, which are used to offset unrelated income, but defers related income until later, if ever) 4. Conversion (investment generates deductions against ordinary income and income subject to favorable tax rates (long-term capital gains)) 5. Leverage (use of borrowed funds to increase size of deductible expenditures) Frank Lyon p. 398 (tax shelter, sale-leaseback, deferral, income shifting; building sale case) Code: § 162, 167? Holding: P is the owner and can take the depreciation deductions. Issue is whether P had sufficient ―incidents of ownership‖ to be considered the owner for tax purposes, and whether P had economic purpose besides the tax benefits. Here, P had a real economic risk on the balance of the NY Life loan, and would own the building outright if Worthen didn’t exercise the option. Therefore, P can take the depreciation on the building, since P is more of a lessor than a mortgagor. Issue: Another ―substance over form‖ question – and here, P’s involvement was found to have substance. Yet AA notes there was no non-tax reason for P to be involved at all! Compare with ACM partnership case. Charitable Deductions (Assignment 16 § 170) Overview § 170(c) defines tax exempt donations. Five steps to receive a deduction for a donation: 1. Must be made to an eligible charitable entity 11
2. Must be a “contribution” – similar definition to gifts under Duberstein (detached and disinterested generosity‖. a. Note that the stakes are higher for individuals in charitable deduction cases, since they don’t have a business deduction option to fall back upon. 3. Must be cash or property (not services – since if you deduct services, you’ll not have included it in your income.) a. The problem with this logic is in 170(e), which allows you to take a deduction for more than the amount you include in your income (but only for property). 4. Percentage limitation of 50% – cannot completely offset your income with charitable donations. This adversely impacts extraordinarily generous people (Professor nun) and people who engage in tax fraud. 5. Must itemize the deduction. Someone who takes a charitable deduction doesn’t take the standardized deduction, which means someone who does take the standard doesn’t gain any marginal benefit from making a charitable contribution. Two Views of the Charitable Deduction Income-defining – a charitable deduction should not be considered ―consumption‖ under Haig Simons. Tax Expenditure – a ―subsidy‖ allocated by individuals, but paid by government, which offers a ―rebate‖ (or incentive) for charitable contributions that creates an upside-down subsidy. Hernandez p. 436 (Quid pro quo, charitable deduction, market comparables; Scientology case) Code: § 170(c) Holding: Quid pro quo deductions are not deductible; this is eventually reversed by IRS regulation. Dissent argues that you should look for a ―market comparable‖, and be permitted to deduct only in excess of what the market comparable price for the service is. Issues: o Payments in excess of cost of services are considered legitimate charitable deductions. o Note that if the donation is property held for less than a year, § 170(e) requires the deduction to be the basis, rather than the FMV/capital gain. Also, if the donation isn’t for the purposes of the charity, the deduction is the basis alone. o Corporate Tax Shelters (Assignment 17) Overview Why should we be concerned about the proliferation of corporate tax shelters? 1) Short-term revenue loss: shelters reduce the corporate tax base 2) Disrespect for the system: race to the bottom problem is created 3) Complexity: ad hoc legislative remedies create piecemeal tax code 4) Uneconomic use of resources: government and private sector spend significant resources used to create, defend, and police shelters What are some common characteristics of corporate tax shelters? 1) Lack of economic substance: participant is insulated from any significant economic risk
2) Inconsistent accounting: disparity between financial accounting treatment and tax treatment of shelter items 3) Tax-indifferent parties: e.g., foreign or tax-exempt entities participate in the deal 4) Marketing activity: shelters are often easy to replicate and are marketed and sold to multiple participants 5) Confidentiality: helps maximize the return on the tax product 6) Contingent/refundable fees and recission/insurance arrangements: as protection against risk, corporate shelters often involve contingent fees or insurance arrangements 7) High transaction cost Shelter Definitions: Joint Committee on Taxation: shelter satisfies one of five-factors: 1) low expectation of pre-tax profit relative to expected tax benefits 2) relatively high taxable income to a tax-indifferent party; favorable tax characterization of income, gains, losses, deductions or credits by a corporate party; noneconomic manipulation of basis for benefit of corporate party but not subject to tax 3) significant reasonably expected net tax benefits and a tax indemnity 4) significant reasonably expected net tax benefits and a reasonably expected ―permanent difference‖ for financial reporting purposes 5) significant reasonably expected net tax benefits and little economic risk ACM Partnership p. 796 (installment sales, tax shelter, substance over form, tax-indifferent parties) Code: § 453 (installment sales) Holding: Transaction disallowed for lacking economic substance. The transaction had incidental effects on ACM’s economic position (ACM sold the notes so as to not realize any loss or gain), and the transactions were not designed to generate a pre-tax profit. The LIBOR rate, although technically unknown, certainly wasn’t random, but there was no attempt to project a ROR. Also, a tax-indifferent (foreign) party absorbed any profits. Issues: Although ACM complied with the letter of the law (like Cottage Savings), Fender and Knetsch suggest that substance over form analysis will prevail.
Marriage Penalty and Kiddie Tax (Assignment 19 § 1) Income Shifting Within Family -- It’s all about ―economic identity of interest‖. Among Unrelated Parties – by contract (Frank Lyon, ACM) “Kiddie Tax” In reality, kids are part of the economic unit, but § 72 treats children as a separate taxpayer. Before 1986, the ability to treat children as separate tax-payers created a tax shelter opportunity. § 1(g) (the Kiddie Tax) made this impossible for children under 18 who have non-earned income, the income is taxed at their parent’s top marginal rate, regardless of the income’s source. (If the income is earned then the children’s normal marginal tax-rate applies.)
Druker p. 465 (Marriage penalty challenge) Code: § 1 Holding: Marriage penalty is constitutional, since if you cannot maintain a) horizontal equity between married couples, b) progressive tax rates, and c) avoid a marriage penalty against some couples (usually those who are dual-career higher earners).
Assignment of Income from Services (Assignment 20) Lucas v. Earl p. 489 (Assignment of earned income; marriage contract case) Code: Tangentially about § 61, but judge-made law. Holding: Income is taxed against the individual who earns it (if earned via services, rather than property – see Blair). This case prohibits assignment of earned income by taxpayers who have a shared economic identity of interest who are trying to defeat the progressive tax rate structure. Issues: o For unmarried/cohabiting couples, this is still the law (although it’s been fixed for married couples by allowing them to file jointly). o This is not about prohibiting the contractual assignment of income (which is done all the time commercially in partnerships, for example). o See also Armantrout, whose employer made payments to his kid’s college trust fund – these were income to Armantrout, not his kids, since they’re essentially compensatory payments that are assigned by contract. Assignment of Income from Property (Assignment 20) Three Themes: Fruit and Tree Analysis (Blair, Earl) Property vs. Human Capital (Blair, Horst, Earl). The court makes an arbitrary distinction between earned income and property income. o Property at some point has to be shifted to another person in its entirety. In contrast, income streams end; the income earner (the tree) cannot shift his entire income because you cannot shift human capital. o The key distinction between Blair and Earl is the property vs. human capital one. The distinction between the two doesn’t work so well for Horst. Reversion (Horst, Blair). Occurs if property or its income is assigned for only a period of time (becoming a ―carveout‖), such that it may revert back to the assignor at some future point. Income that reverts back to the assignor is taxed to the assignor. o No reversion in Blair because he assigned a portion of the life trust income to his kids for as long as he lived. Blair p. 497 (Assignment of income from property, ―fruit and tree‖ doctrine) Code: § 102, § 61
Holding: Assignment of a portion of a life interest to children is ok, because it’s a) about property income not salary income, and b) Blair did not retain control over the ―slice of everything‖ that he gave away (fruit and tree), and there’s no reversion to Blair. Issues: Blair didn’t just give cash, because this would be taxed to him under § 102, and he wanted to income-shift to his kids.
Horst p. 499 (Assignment of income from property, bonds case) Code: § 102, 61, eventually § 1286 Holding: P retained control over the principal (―tree‖), so he is taxed on the income from the coupons (―fruit‖). Distinguished from Earl because this is property (not services), distinguished from Blair because of ―control‖ issue. Issues: Key point: if you want to income shift, do it via a slice of property. Overruled by § 1286, which allows basis of bond to be allocated between retained portion and the coupon portion.
Introduction to Capital Gains (Assignment 26) Applicable Code Sections: § 1(h). Lists maximum capital gains rates for different types of capital. § 1001. Determination of amount of and recognition of gain or loss from disposition of property. In general, all gains/losses are recognized unless otherwise provided. § 1011. Adjusted basis for determining gain or loss from disposition of property. § 1012. Basis of property equals cost of the property, except with capital gains/losses. § 1016. Adjustments to basis § 1211. Limitation on capital losses: (a) Corporations’ losses are limited to gains. (b) Non-corporate taxpayers’ losses are limited to gains + the excess of such losses over gains up to $3000 (or $1500 if married and filing separate return). § 1212. Capital loss carrybacks and carryovers. (In general, losses can be carried to succeeding years until they are expended). § 1221. Capital asset defined § 1222. Other terms relating to capital gains and losses. § 1223. Holding period of property. § 1231. Property used in the trade or business and involuntary conversions. § 1245. Gain from dispositions of certain depreciable property. The Mantra Capital Gains has NOTHING to do with Capitalization. Capital Gains are the gain or loss from the sale or exchange of a capital asset. o Ask: Is there a sale or exchange? o Ask: Is it a capital asset (check § 1221(a)) Capital losses can only be offset by capital gains; individuals can only offset $3k in capital losses per year (§ 1211(b)), but can carry forward outstanding losses. This is meant to avoid ―perfect hedging‖ in holding winners, selling losers, and realizing tax losses without economic losses.
Capital gains/losses can be short term or long term (more than a year). Tax treatment tax excess gain as ordinary income tax excess gain at preferential capital-gains rates tax short-term gain as ordinary income and long-term gain at preferential rates up to $3000 loss may be offset against ordinary income; remainder of loss is carried forward indefinitely until fully utilized
Situation Net short-term gain > net long-term loss Net long-term gain > net short-term loss Net gain (long-term, short-term, or both) Losses exceed gains
Three Reasons for Preferential Capital Gains Treatment Bunching: If you hold an asset for a long time and then sell, you may have a ―spike‖ in your marginal tax rate that makes you look wealthier than you really are. o This over-taxation occurs because of a combination of progressive tax rates and the realization requirement; is only a concern if the capital gain actually bumps you into a higher marginal tax bracket. o A better solution would be to allow income averaging, which would spread the gain over the number of years the asset was held. Lock-in: CG preference tries to encourage people to sell assets that they might otherwise hold onto in the hope of a stepped-up basis under § 1014. Tries to make people act more as though they would in an unregulated market. Inflation: Some of the gain/loss may be due to inflation, rather than any ―real‖ gain or loss in the asset’s value. This is caused by the realization requirement delay, but is only a problem because the tax code doesn’t index assets for inflation. Three Arguments Against Preferential Treatment: Fairness: Tax all income the same Complexity: This system introduces complexity. Inequity: This preferences high-bracket taxpayers and produces too little savings and risk-taking for the cost to the fisc. Malat p. 552 (Capital assets, ―primary‖ motives for trade/business or investment; land sale case). Code: § 1221(a)(1) Holding: In determining whether an asset is being held ―primarily‖ for sale to customers in the ordinary course of his trade or business‖ in § 1221(a)(1), ―primarily‖ means ―principally‖ rather than merely being a ―substantial‖ purpose. Courts may look to taxpayer’s activity or involvement in determining whether it was a ―primary/principal‖ activity of the taxpayer. Issues: IRS didn’t try to use § 1221(a)(2) (property used in trade or business) provision because they didn’t have an apartment building yet, and because calling it § 1221(a)(2) would turn the asset into a § 1231 asset, giving it capital gains and ordinary losses! Malat wanted to be in this category; IRS would never do this, so they’re stuck arguing § 1221(a)(1).
Bramblett p. 556 (Property held for sale to customers, dual-purpose holdings; Mesquite East case) Code: § 1221(a)(1) Holding: Taxpayer land holder was not engaged in a trade or business of land sales, and was not holding the property primarily for sale in that business. P bought for investment purposes, and structured the transaction to sell to another entity that would develop. Although it looks somewhat like a sham (because the parties are all the same), there’s genuine economic substance here. Court uses a 7-factor test (nature/purpose of ownership, extent of efforts to sell, number of sales, extent of advertising, supervision exercised by taxpayer over the representative selling, and time devoted to selling). 560. Issues: This may be a sham, but there are problems applying ―substance over form‖ when there are separate corporate entities, and when courts want to respect those forms. Section 1231, 1245, and Recapture (Assignments 28) § 1231(b) – Capital Gains and Ordinary Losses Allows § 1221(a)(2) assets to produce capital gains and ordinary losses – ―property used in the trade or business, or a character which is subject to the allowance for depreciation in § 167, held for more than one year, and real property used in trade or business held for more than one year‖. Does NOT apply to inventory of a company, however. § 1245 -- Anti-Conversion Prevents people from fast-depreciating (and taking ordinary-rate deductions) and then later selling for capital gains. ―To the extent of previous depreciation, future gains will be taxed at ordinary rates.‖ Example: o Start by calling the asset ordinary. o Then, § 1231 appears, and says ―they’re not capital assets, but we’ll grant them capital gains treatment for the odd case when machinery appreciates! o Then, § 1245 comes in and limits those gains in the event that the appreciation in the sale price is actually due to over-fast depreciation. Hedging (Assignment 29) Corn Products p. 572 (hedging) Code: § 1221(a)(7) hedging transaction Holding: Futures in raw material used by a manufacturer are not capital assets, but need to be taxed at ordinary rates. Test was that it was ―business related‖ (since futures were a substitute for actual corn, which was ―vitally important‖ to the core business) as opposed to ―investment related‖. Issue: Unintended result was that people started relying upon Corn Products for the premise that anything related to business was ordinary – so losses on business-related should be ordinary as well! This led to corporations buying capital-like assets -- if they appreciated, they sold for capital gains, and if they depreciated, they claimed Corn Product losses!
Arkansas Best p. 575 (hedging, limits Corn Products) Code: § 1221(a)(1) Holding: Returns to a more literal reading of § 1221(a)(1), says that it doesn’t matter if an asset is integral to the business or not – it depends on your motives in holding the asset. Limits Corn Products to ―substitutes for inventory‖, and bars blanket protection for hedging. Issues: § 1221(a)(6-8) eventually reestablish ordinary status for hedging instruments. `