Student ID #: 90676032 TAXATION B2, PROFESSOR ZOLT, MAY 1, 2008 STUDENT ID #: 90676032 Part II Question 1: Auction of the Portraits by Harvard

Law School There are several ways to treat the auction of the portraits. These alternatives are discussed below. Donation as a Charitable Gift to the public Interest Auction: Harvard might argue that this is a charitable donation to the Public Interest Auction, which might be a separate entity eligible to receive deductible donations under § 170. In this instance, Harvard would likely to attempt to deduct the FMV. However, typically when goods are donated and then auctioned, the deduction is limited to the amount realized from sale of the goods (in order to avoid valuation scams). Auction as a Sale: Perhaps the most obvious approach would be to treat the auction as a sale of the goods. This treats the auction as if it were an arm’s-length transaction. If the transaction were characterized this way, the chief questions are (1) what is the amount of loss or gain, and (2) should this amount be treated as capital gains or losses. Gain or Loss: The gain or loss is the difference between the price amount received $5000 per painting and Harvard’s basis in the property. If Harvard purchased the property, the basis is the amount paid. If the property was donated, Harvard takes the basis of the donee. Harvard could argue that the paintings were ‘inventory’ and that by having an appraisal done, they effectively priced their inventory at current value as permitted by § 472 (for FIFO taxpayers). However, if Harvard had wanted to do this, they should have realized gains on inventory at the time of appraisal. If this had been done, then Harvard could have attempted to take a loss of the difference between the FMV and the sale price.


Student ID #: 90676032 Ordinary Income / Capital Gains: If Harvard either purchased the property itself, or received the property from someone who purchased it, then the proceeds likely should be treated as capital gains. However, if the property were received by gift from the creator (or indirectly by a series of gifts) then the sale could be treated as ordinary income. § 1221(3)(C). However, given the rarity and value of the paintings, it is likely that they will be treated as a ‘collectible’ and taxed at the special 28% rate. However, it is unlikely that this transaction will be treated as a sale of the property. The Auction provided the opportunity for the Professors to buy the property below market. The auction was limited only to Harvard Professors. Given this, alternative treatment would be better. Advertising / Production of Goodwill: Harvard might argue that the Auction was a form of advertising and so currently deductible. They would argue that given the importance of the event to the community, they—like Skadden, Sullivan and Kirkland—want to be represented well. If this argument were accepted, the full value of the property would be deducted. The IRS might argue against a deduction because this grant of property produces goodwill going forward between the school and the teachers. However, this is unlikely to prevail—it is true of all advertising. Nevertheless, it is unlikely that this would be treated as advertising. Advertising belongs in the category of ‘ordinary and necessary’ expenses (§162)—and this is simply too strange of a method of advertising to be respected as such by the IRS. Auction as Compensation for Professors: The professors have clearly benefited from the University’s largesse. One way to treat this closed auction would be as a benefit to the faculty— compensation for services. The grant of the exclusive right to bid at the auction can be viewed as the grant of an option to purchase paintings from the school. This option was ‘exercised’ when the professors purchased the paintings for $5000. The amount included in income for the


Student ID #: 90676032 professors would be the difference between the fair market value of the paintings and the amount paid. This would also be the amount deductible by the school. It would be treated as compensation for employees under § 162. Under § 83(h), this would be deductible at the time the Professor’s realized income. This would be when the property was actually received at the auction. Question II: Treatment for the Teachers Purchase: The teachers might argue that this is simply the purchase of a good from the school as an arm’s length transaction. If we treated the teachers as ‘dealers’ in art, this expense would be ‘capitalized’ in their inventory. The cost would represent their ‘cost of goods’ and their subsequent profit would be the difference between this ‘cost of goods’ and the sale price. Gift Treatment: One might argue that this is a gift, with no taxes imposed (or that the difference between the FMV and the $5000 represented a gift). This would likely fail for two reasons: First, § 102(c) bars gift treatment for transfers from an employer to an employee. Second, it is unlikely that this gift was made out of ‘detached, disinterested generosity,” Duberstein, because of the school’s obvious interest in making its employees happy. Accordingly, gift treatment is inappropriate. § 132 Fringe Benefits: The taxpayers might argue that this is should be excluded from income as a de minimis fringe benefit. Possible candidates are §132(a)(2) and § 132(a)(4). However, it is likely that neither applies. The property is not offered for sale to customers, so the ‘qualified employee discount’ does not apply. And the amount of benefit is simply too great to qualify under § 132(a)(4) as a ‘de minimis’ benefit.


Student ID #: 90676032 Compensation: This is probably the best way to treat the paintings. They would be taxed on the difference between the FMV and the $5000 paid. This would be included in their ordinary income, and they would be taxed on that amount. Question III: Treatment of 2007 Sale Much of the answer here depends on the treatment of the property in the prior analysis. If the auction were treated as an arm’s length sale: The Professors have a basis in the property equal to the price paid. The amount above this would be treated as gain. The next question is whether it is capital gain or ordinary income. The professors held the property for less than one year, accordingly, the property cannot get long-term capital gain treatment. If it was treated as short-term capital gain, it would be taxed at the Professor’s ordinary income rate. As noted above, paintings might be treated as collectibles and taxed at 28%. If the transfer were treated as compensation: We would have included in taxable income the fair market value of the property minus the $5000. We would assume that the services provided by the teachers was equal in value to the difference between the FMV of the property and the $5000. Accordingly, the teacher’s basis in the property would be its appraised FMV. When they sold the property, accordingly, they would have no income. There is the possibility, that the property would be sold for less than the FMV that was included in the previous year as income. This would, in essence, be a claim of right problem. They included too much in the prior year (overestimating the FMV) and in the second year, selling the property for less than it was anticipated to be worth, they suffered a loss. Under § 1341, they could either take an immediate loss deduction, or if the loss was greater than $3000, they could recompute income in the prior year using the sale price rather than the appraised FMV as their income, and be reimbursed for the resulting difference in taxes in the prior year.


Student ID #: 90676032 Gift: If the property were a gift, the basis of the property would be Harvard’s basis in the property. The difference between this and the sale price would be gain. If Harvard, in turn, had received it as a gift, then this would be treated as ordinary income under § 1221(3)(c). The gain would be the difference between the basis and the price at the May 2007 auction. Who’s is taxed on the gain?: The five professor’s worked together to bid on and sell their paintings. However, the actual paintings were bought, and presumably legal title vested, in the professors individually. It was only after the paintings were sold that the money was divvied up and each professor given an equal share. Viewed this way, the proceeds from the May 2007 Auction should be attributed to each individual. This would mean greater income, and greater taxes on those whose paintings, by chance sold for more money. However, this might be legally proper. This appears to be a transfer of income after it has been earned. This is not permitted as a diversion of income. Eubank. On another view, however, the professors could be viewed as having formed a legal ‘partnership’ when they agreed to bid as a noncompetitive team. Under this view, the income would not be attributable to each individually, but to the partnership as a whole. The $50,000 proceeds that each received could therefore be considered a ‘distribution of income’ from the partnership profits, rather than a ‘redistribution of income’ from individual to individual. Under the former idea, each individual should be taxed on $50,000. Under the latter, each should be taxed according to the value of the painting sold by that individual. Although this would seemingly be barred by Lucas v. Earl, there is a chance the ‘partnership’ arrangement would be viewed as a real business organization, not as an attempt to divert income through a prior agreement. Part III


Student ID #: 90676032 There are three standard criteria for evaluating a tax proposal: administrability, economic efficiency and fairness. In addition, we might address whether this problem can be addressed through other provisions of the tax code, and whether the tax code is a good way to address the fundamental problem. The first question is whether this proposal would be administratively feasible. Taxpayers might be tempted to lie about their marital status in some instances (although given the occasional marriage ‘bonus’ in the tax code this temptation already exists), this could be dealt with in the same way as the IRS dealt with abuse of dependent deductions—requiring a Social Security number (in this instance of the spouse). There is certainly some devil in the details— what to do about people who get married / divorced mid-year etc., what to do about people receiving the EITC—but these are details, not obstacles. This proposal would not require heroic calculations by the taxpayer or impose an enormous administrative burden. Single parents and non-custodial parents could easily calculate their new taxes. From an economic efficiency standard, it likely achieves exactly its intent. It provides a strong incentive for parents to get married—depending on which side of the marriage / single divide you stand, it provides a strong carrot or stick through the tax code. Whether encouraging marriage is a valuable and valid goal of the government is for politicians, not tax analysts. This proposal is most troubling from a fairness perspective. Given that single parents are generally less well-off than married parents, this is likely to be regressive, adding an additional tax burden on those with the least income. Moreover, in addition to having the least income, single parents also have a greater burden compared both with non-parents (who don’t have child expenses) and with married parents (who can share expenses such as housing etc.).


Student ID #: 90676032 This proposal does have one ‘progressive’ element. Because it is calculated as a percentage of regular tax liability, which is lower of lower income individuals, the amount of the tax, and its percentage of income will be lower for lower income parents. In this sense, it is actually welltuned. The harshness of the penalty is adjusted for income levels. There still remains the question of whether this is the best way to achieve the goal of encouraging marriage. Alternative first steps might be attempting to curb the marriage ‘penalty’ imposed on many two-earner families—perhaps by requiring separate filing for everyone. If the idea is to improve child-welfare, the credits for childcare—more substantial than § 129 might be more appropriate than this proposal. There is the additional question of whether the ultimate goal of the proposal, childwelfare, is best addressed through the tax code. Taxes are oftentime a blunt instrument, and due to the various deductions, etc, the tax liability might not adequately reflect, for instance, ability to pay, and hence those hit with the single-parent tax will be less reactive than anticipated. More direct methods of improving children’s achievement are available—improving schools through direct expenditure, providing government childcare etc. would prove a better too than attempting to affect children’s outcome’s indirectly through the route of attempting to impact marriage behavior through the tax code. Generally, the tax code is probably not the best mode of addressing this problem. It seems unfair to tax those who might be the neediest—both as a matter of income levels and of their living expenses. And alternative means are available—provision of childcare, better schools etc.


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