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Federal Taxation of Individuals Outline

Professor Capital Gans - Spring 2013


Chapter 1
Deference and Tools of a Tax Lawyer
TOOL #1: The Code

Internal Revenue Code of 1986 (IRC)


This is the bible
Title 26 of the USC

TOOL #2: Regulations

Two different kinds of regulations:


Interpretive Regulations ( 7805 of the Code)
Authorizes the Secretary of Treasury to issue regulations interpreting
various sections of the code
Legislative Regulations
Regulations issued under a specific grant of authority
Allows the secretary to create gap-filling rules because they have more
expertise. Congress says Heres the issue, you make the law
Agency is quasi-legislature

Notice and Comment


If the Treasury department and IRS want to get together and issue a new regulation,
they have to issue Notice in the Federal Register with a preamble explaining the
problems, concerns, and a solution (proposed regulation).
Invite Oral and Written comments from taxpayers and provide a deadline
Almost all regulations are issued with Notice and Comment
Sometimes a temporary regulation can be effective immediately without
notice and comment. Some people raise questions of the validity of this.

How much deference should be given to a regulation?


Mayo Foundation v. US:
Quick Facts: Mayo clinic didnt want to pay certain tax. Prior law was an 8th
circuit decision which helped them, however, Treasury issued a 7805
regulation (Interpretive Regulation) overruling the 8th circuit. Mayo
challenges this regulation. Mayo wanted the National Muffler standard to
apply because validity would have rested on whether the regulation was
issued in the heat of litigation.
Issue: What standard is applied when challenging the validity of a
regulation?

Chevron Standard
For Interpretive Regulations (7805)
(1) Is the statute ambiguous?
If not, the analysis is over and the regulation fails.
(2) Did the agency reach a reasonable resolution of the ambiguity?
(Did the agency stay within the scope of the ambiguity)
Administrative Convenience can play towards a reasonable
resolution.
Whether the regulation comports with statutory construction
precedent. In Mayo, the court said the IRS followed a canon of
construction that exceptions from taxability are to be
narrowly construed; therefore reasonable.
For Legislative Regulations
(1) [Same] Is the statute ambiguous?
(2) [Different] Was the agency arbitrary or capricious in resolving
the ambiguity?

Regulations Trumping Precedent


The agency is a prosecutor and a rule maker. Gans finds this problematic.
National Cable:
Held: Agencies can trump precedent, including SC precedent, UNLESS the
court held that the statute was unambiguous.

Retroactive Regulations
General Rule: The IRS does NOT have authority to issue retroactive regulations
UNLESS a statute says they can. People rely on the law.
Even if the agency has the power to write a retroactive regulation, they still
can be sued for abuse of discretion.

Held: Chevron standard. Mayo now brought Chevron into the tax world.

In 1996, congress amended 7805 to say that regulations can only be prospective.
ONLY Applies to code sections enacted AFTER 1996.
Most sections were enacted before 1996. IRS can issue retroactive
regulations for these but they can still be sued for abuse of
discretion.
Exceptions:
7805(b)(3) for taxpayer abuse: IRS has the power to issue
retroactive regulations, even for section after 96, to close down
taxpayer abuse. This exception is not well tested in the courts yet.
7805(b)(2) for promptly issued regulations: If the regulation is
issued within 18 months of enactment of the statute, IRS can make it
retroactive to the date of enactment.

What standard for interpreting an ambiguous REGULATION? (note statute)


Ex: Agency interpreting its own regulation with a brief or revenue ruling

Auer Deference: UNLESS agencys interpretation of the regulation is PLAINLY


INCONSISTENT with the text of the regulation, the court defers to the agencys
interpretation.
High standard of deference.
Reason: They know what they meant.

TOOL #3: Revenue Rulings


A Revenue Ruling (RR) is an official publication by the IRS announcing their opinion on an
issue authorized by 7805 of the code.
Its important for a tax lawyer to know if theres a relevant RR on point.
Issued without Notice and Comment
RR DO NOT get Chevron Deference
RR are rare now. IRS rather put it in a regulation to get Chevron deference.

RR Deference
RR used to resolve ambiguity in regulation: = Auer Standard (higher than Chevron)
RR used to resolve ambiguity in the code: = Skidmore Deference (lower than
Chevron)
Skidmore also applies to any other form of IRS interpretation of the code
(except regulation, thats Chevron deference). Ex: briefs, etc...
Skidmore Deference:
Courts ultimate question: Whether or not this interpretation is persuasive.
Subsidiary factors:
(1) Was the interpretation (the RR) issued contemporaneous with
the enactment of the underlying statute?
Versus if the interpretation his issued in the heat of litigation.
(2) Consistency: Has the agency been consistent?
This is the big difference between Skidmore and Chevron.
Chevron doesnt care about inconsistency.
Ex. In Mayo, the IRS issued a regulation to change the law
that was very inconsistent, but it didnt matter because
Chevron deference is used there.

WHAT IF: Taxpayer friendly RR and IRS wants to abandon it


Lower court WILL NOT hear argument from the IRS that is contrary to their
own RR UNLESS:
They argue that the statute is UNambiguous and they got it wrong.
Separation of powers doesnt permit executive branch to re-write
congress unambiguous statutes.

Overview of Deference
Interpreting Document

Ambiguous Regulation

Ambiguous CODE

Interpretive Regulation

Chevron 1
(reasonable resolution)

Legislative Regulation

Chevron 2
(arbitrary & capricious)

RR

Auer

Skidmore

Other/ Anything Else

Auer

Skidmore

TOOL #4: Private Letter Rulings

A Private Letter Ruling (PLR) is a ruling that is issued privately to an individual taxpayer
at their request.
Hypo: Client wants to do a transaction but is worried about the consequences and
there is no clear answer. Lawyer drafts a letter to the IRS detailing the facts, relevant
authority, and proposed outcome and asks them to rule on it
IRS charges a user fee (can be expensive, Gans case charged $14,000)
2-3 weeks letter Gans got a phone call (after submitting request with check)-- IRS
says they are litigating in this area and does not want to say anything to prejudice
the litigation.
If they refuse to rule, you get your money back, HOWEVER, hiring a lawyer to do this
is expensive as well-- and we gots to get paid nigga.

IRC 6110: PLRs may not be cited.


Still good to be used as a guideline and is a great research tool. They analyzes the
code, regulations and RRs-- does the research for you!
They can also be used to defeat penalties. If the IRS rules a PLR in your favor but
later changed their position, the PLR may be cited to defeat the penalty.

Privacy: Often times they contain confidential information. Since they are published rulings,
the confidential information is redacted.

TOOL #5: Court Decisions


3 Possible Courts the taxpayer can choose to litigate (forum shop)
U.S. Tax Court
U.S. District Court
U.S. Claims Court

U.S. Tax Court


National court in DC, judges from the tax court will ride the circuit which means a
tax court judge would come to NY to try the case.
19 judges on the tax court who are all tax experts.
No Jury Trials: Judges resolve questions of fact
Appeal: Goes to Circuit Court where taxpayer lives

NO NEED to pay the IRS first if going to tax court


IRS sends a Notice of Deficiency which gives 90 days to file a petition in the
tax court. If filed, the IRS is stayed from seeking collection until tax court
case is fully resolved.
This temporary relief... but must pay the IRS the interest accrued if you lose
Most clients want to sue immediately in tax court

3 Kinds of Opinions the Tax Court can issue

Court Reviewed Decision: Tax court judge files opinion with Chief Judge who
decides its controversial and it will be reviewed en banc (all 19 judges will
look at it and can concur or dissent)
Opinion is published by official tax court reports
Has a lot of precedential effect

Official Opinion: Tax court judge files with Chief Judge who thinks its an
important issue, but not controversial and therefore no need for court
reviewed opinion.
Also published by official tax court reports

Memorandum Opinion: Chief Judge looks at the opinion and theres nothing
novel about the issue.
Not published in official reports but private publishers will come and
publish these opinions. (TC Memo 2011-5)

U.S. District Court


Most district court judges are not tax experts
Juries are available! (only forum for this)
Appeal: Based on where the taxpayer lives

U.S. Claims Court


Sits in DC and hears claims against the US government, such as claims for refunds.
Less expertise than tax court
No Jury trials
Appeal: Goes to Court of Appeals for the Federal Circuit

Forum Shopping
Jury/Sympathy:
Go to district court if you want sympathy from a jury

Expertise:
Tax court is full of tax experts so if the law is against you choose district or
claims court.
If its a complex law in your favor, you may want tax court.

Payment:
Dont want to pay up front = tax court
Pay and sue for refund = district or claims court

Appeal:
Tax Ct. appeal = Federal Circuit (bound by this authority)
District and Claims ct. appeal = taxpayers home circuit (bound by authority)
Go where the law is in your favor

Tool #6: Legislative History


Constitution: Tax legislation starts in the house
5 Step process
Committee reports provides rich source of information and often give examples
1) House
House Ways and Means Committee:
Specialized in Tax matters / Tax Experts
Once approved by vote goes to House Floor
House Floor
House Ways and Committee Report: memoranda explaining what they have done, what

present law is, what the problem is, why change needed, this is the change (proposal) and
how it would work
provides those not on the committee a way to read in plain english what is going on
Once voted on by house floor goes to Senate

2) Senate
Senate Finance Committee:
tax backgrounds
vote on the proposed legislation
Senate Finance Committee Report: what House proposed and how they feel about it, if they
would modify it
Send to the Senate Floor

Senate Floor
votes on the proposed legislation

3) Conference Committee: If the final bill which passed the House and Senate don't agree entirely and are not
entirely the same
Both House and Senate members
Take the bill from House and bill from Senate and find compromise
Once agreed by vote goes back to the House and Senate for final approval vote
Write Conference Committee Report prior to sending it for final approval vote
4) Once approved by both houses Sent to President
5) President
Can (but most likely wont) write memo before approving it

Two Theories of Taxation


- Dividing up the cost of government so it can be fairly shared by members of society
1

Base Taxation on Benefits: Divide the cost of government based on how much benefit each
person takes from the government [not easily calculated]
a Opposition to Benefits Theory: will end up with regressive tax system
b Regressive Taxation: higher you go on income scale, the less rate of tax you pay (the
lower your percentage would be)
i Ex. $10$100; $1 benefit = originally 10% of income now 1% of income
ii As income goes up, your tax rate would go down ,while benefits remain the same
c Progressive Taxation: higher you go on income scale, the higher the rate of tax you pay
[Our System]
d Flat Taxation: as you earn more, pay the same %

Base Taxation on Ability to Pay: How much ability to contribute to the cost of government
does each person have this year
a what factors should be considered: medical bills, mortgage interest on house?

Tax Rate Table


Section 1 of the code: every year the IRS adjusts the table for inflation
Calculation:
[63 of Code] Taxable Income = (Gross Income - Deductions)
Apply % to taxable income
Tax Rate Schedule for 2012: Federal Tax (NEXT PAGE)

[Single]
Taxable
Income

Tax Rate
(%)

400k

[Calculated
Tax $ for
bracket]

[Married]
Taxable
Income

Tax Rate
(%)

[Calculated
Tax $ for
bracket]

39.6

450k

39.6

1650

35

51,650

35

215,100

33

70,983

175,300

33

95,400

28

26,782

86,650

28

51,600

25

12,900

73,900

25

18,475.00

27,325

15

4,098.75

54,650

15

8,197.50

8,925

10

892.50

17,850

10

1,785.00

Ex. $36,325.00 Taxable Income = (8,925@10%=892.50) + ( 27,325@15%=4,098.75) = $4991.25 Tax Owed

What is my Tax Bracket??


Average Tax Rate = [Calculated Tax Owed / Taxable Income] * 100

Ex. ($4,991.25 Tax Owed / $36,325.00 Taxable Income ) * 100 = 13.741% Average Tax Rate

Marginal Tax Bracket:


What is my rate of income if i take in one additional dollar??
People more interested in Marginal Tax Braket
If i take in more money / expect a deduction = how much tax will i generate??
Only get a change in tax bracket if the payer is on a breakpoint of a bracket
Ex. Income 8,925 + 1 $. Was all at 10%, now the addition of 1$ raised , that 1 dollar is taxed
at 15%.

Ex. Income 8,920 + 1$. Was all at 10%, even with additional 1%, still in 10%.
Purchasing a home could result in a lower marginal bracket, bc of the new deduction to
taxable income

Tax Policy Perspective


Average Tax: speaking in terms of equity, is it fair to discriminate for the differences in
average between different categories of taxpayers (average of someone making 34K v.
average of someone making 75k)
Marginal Bracket: if marginal bracket becomes too high, might disincentivise people from
working / continuing to work
Progressive Rate Schedule
Theory in Support: Declining marginal utility of the dollar
$1 to broke ass dude means more than $1 to a rich ass dude
1 extra dollar to poor dude goes further than $1 to rich person who uses it to light a cigar
utility of $1 declines as you climb the income ladder
Tax such that everyone contributed their fair share: tax on ability to pay and so rich person
taxed more, so they feel the same pain as the poor person
Flat Tax: would work against this principle

Arguments Against:
Flat Tax: Simpler
Libertarian view: my money which i earned reflects my worth, and inappropriate intrusion
to take what i am entitled to
Progressive reply: not just your attributes which contributed to your wealth and
success
Progressive Rate could stifle incentives
As marginal bracket goes up - will cause people to not want to work - not worth my
time to work if large % is getting taken by gov
progressive reply: is 35% versus 20-22% really such a large amount to dissuade
someone from working?
Feminist Argument:
w/ joint filing: spouse 1 working and income at top of bracket; if spouse 2 starts to
work, marginal bracket of spouse 2 starts at the next bracket [could file separately
though - very rare]
spouse 2 also incurs additional cost to enter the workforce reducing the income
earned
Flat tax: would eliminate this issue
Leads to Marriage Non-Neutrality: tax law in some way causing people to get married or
avoid getting married
Marriage Neutrality: Penalty / Bonus
Width of taxable income brackets different for married
10% + 15% brackets doubled [no penalty]
higher brackets not doubled
Causes penalty (pay more tax) / bonus (pay less tax) when deciding if you will get married
or not = non-marriage neutral
Argument for marriage penalty:
Economics of Scale: when two people put income together, certain savings, one
house, cost of living goes down, and increases ability to contribute to government
Argument against marriage penalty:
people can choose to live together verse getting married
discourages marriage
To avoid a potential marriage penalty: can continue to file separately
Couple Neutrality
Mathematically impossible to have a progressive tax-rate schedule and marriage neutrality and
couple neutrality
Couple Neutrality: any couple with an income of X should pay the same tax as any other
couple with an income of X regardless of how the income is distributed between the two
Can avoid marriage non-neutrality by file separate returns
NO way to avoid couple non-neutrality in progressive:
Ex. #1 earns and #2 doesnt
married: joint file and gets benefit of a bigger width for tax rate
Couple: have to file separately and keep a higher bracket, even though similar
earning distribution compared to married couple

Chapter 2
Gross Income
Intro
Section 61: Defines gross income
Gross income essentially means economic benefit
(Glenshaw Glass) Punitive damages was gross income. Abandoned old rule that it
was income from capital or labor.
Now, income where there has been an undeniable accession to wealth,
clearly realized, and over which the taxpayer has complete dominion.

A court will find that section 61 is an all-encompassing section (congress intended this)
In doubtful cases, air on the side of gross income

Treasure Trove:
First Question: Is it Gross Income?? [Economic Benefit]
Rev. Rule: Someone who finds treasure trove has income
Treasury Regulation: 1.61-14: Miscellaneous items of gross income: treasure trove
constitutes gross income for taxable year in which it is reduced to undisputed
possession

10

2nd Question: Timing - When is it gross income?


Tax brackets change and will affect the calculation for tax owed
Affects interest calculations which the IRS is entitled to
(Cesarini) Purchased piano in 57, found $4,000 in it years later.
Gross Income? = YES, economic benefit.
Was it income in 57 when he bought the piano, or when he found the cash
years later?

Analysis: Reduced to undisputed possession


Look at State Property Laws - when rights are acquired under state law??
Mere label provided by state statute does not change undisputed possession
- look at substantive rights
Ex. NY passes law - when you find something, you are nominal
holder except for true owner, and not deemed income for IRS Substantively STILL possession even with label

Timing affects ability for IRS to sue Taxpayer


6501: Statute of Limitations: Generally 3 years from filing date
Exceptions:
1 SOL starts after filing date
2 Fraud: NO SOL

IRS has burden of proof: by clear and convincing


evidence
Taxpayer KNEW it was income and didnt report it /
willfully filed false return
Civil Fraud: 75% of your tax penalty [Ex. owe $100;
75$ Penalty, Plus Interest]
Ignorance of the law can be a defense in tax world
Taxpayer omits more than 25% from gross income - SOL 6
Years
raises suspicion and gives IRS more time

Illegally Gained Income / Treasure trove / Loan


Ex: Steal $, Find $, Borrow $
Economic Benefit -- YES
Count as Taxable Income?
Regulation 61-14: Illegally earned income is still income

Analysis: Spectrum based on probability of repayment


Thief: LOW/NO likelihood of repayment (not innocent) = Taxable Income
Find Money: LOW/NO likelihood owner will come reclaim (innocent) = Taxable
Income
Loan: HIGH expectation of repayment = NOT taxable Income

Taxpayer Who Disgorges Income in a Later Year (Three Choices)


1 Ability for Taxpayer to amend return/request refund:
6511: Cannot file claim for refund more than 3 years out.
2

(General Rule) Allow taxpayer to take a deduction on his return when he makes the
repayment
Deduction: dont have to pay tax on that dollar
Problem when marginal tax changes from year reported and year disgorged
Ex. 50% bracket when you paid $6000 income = $3000 tax owed; Repaid dude his
$6000 but now in 10% bracket = get $6000 deduction this year but you are only in
10% bracket = ($6000 x 10%) $6000 deduction worth only $600 tax savings now.

1341 (Special Treatment): Taxpayer who reports income in previous year and disgorges it
in later year, will give you a refund based upon the higher bracket in the earlier year
Narrow exception to general rule
Requires more than $3000
Does Not apply to thief's only innocent people
Taxpayers choice: use 1341 to get the benefit of previous tax bracket or use
deduction in current tax bracket

11

Employer offers to pay employees federal income tax


Side Note: Employer is required to withhold some income and sends to IRS, after filing
return IRS may send refund if overpaid after deductions.
If employer offers to pay federal income tax for the employee, creates problem:
Counts as Additional Gross Income to employee?
275: not entitled to deduction for paying federal income tax
Regulation 1.61-14: If Employer pays your income tax, it still counts as gross
income.

Fundamental Principle: If someone is paying off my bill (discharging taxpayer obligation)


that is economic benefit to taxpayer and is gross income.

Ex. Two situations, same person; tax bracket 50%


1 Employer pays $100k @ 50% tax = $50k tax owed Employee keeps $50k
2 Employee worth $100k Employer pays employee $66k, and pays the 50% tax owed on the $66k to
IRS, which is $33k (Employer paying $66k +$ 33k). Employee keeps the $66k.

FORM OVER SUBSTANCE!! [No Code Section but available IRS Argument]
Creates Inequity and Distortion.
Inequity: Two people doing the same thing but one is taxed & one isnt
Distortion: As a result of the tax law itself someones behavior/choice is influenced

Barter Transactions
Rev Rul 79-24: Barter transactions constitute gross income
In reality, no mechanism for catching this and hard for IRS to deal with
Form Over Substance
Ex. Two Situations with two people
1 One needs his house painted and painter needs legal advice. Agree to exchange and that value of legal
work and paint job $5k each.
a Constitutes economic benefit even though it is not cash (non-cash benefit has economic
benefit nonetheless)
b BOTH lawyer and painter have $5000 of benefit = gross income.
2 Painter comes to my house and paid $5k. Painter comes after payment and asked legal question
which costs $5k and pays.
a Painter and Lawyer exchanged checks for $5k.
b Constitutes Gross Income for both of them.

12

Two people have difference in form not substance = should be taxed the same

Purchase Price Reduction


Rev Rul 79-66: Purchase Price Reductions are not taxed as gross income
Ex. Manufacturer Rebate, Credit Card Reward Points; sometimes Frequent Flyer Miles
Ex. Buy a car and costs $20k. Told if you buy now, will get $1k check as rebate in a week.
Getting $1k check economic benefit?
Transaction has not created any economic benefit!
Substance: Looks like $1k loan to car dealer for a week = NO economic benefit; $1k loan and
paid $19k for car
Represents a Deduction in the Purchase Price = $1k rebate check NOT Gross Income [Rev
Rul 77-66]

Frequent Flyer Miles


General Rule: Frequent Flyer Miles should be viewed as purchase price reduction and not as
income if i buy ticket and earn frequent flyer miles myself
Ex. Pay $400 for ticket and get some miles. Miles = gross income?
Nothing more than purchase price deduction (of the bought flight) and not economic benefit,
i.e. NOT gross income

Problems:
Employer buys the tickets, employee gets the miles:
Still Purchase price reduction but EMPLOYER is enjoying it not employee
(miles are not income to employer)
Employee gets miles from employer, as fringe benefit
Benefit to employee = income to employee
HOWEVER, hard to value frequent flyer miles given to employees
Administrative Convenience: difficulty in determining benefit
2002 Service Announcement (ANN 2012-18): Service says we are studying
employer provided frequent flyer mile issue and will get back to you - but
for now dont have to report it

Employee converts miles into cash!


If the Employee can turn miles into cash it is now easy to determine the
Benefit = Taxable!

Ex. Spend $100, get $1 back from credit card company


Analysis: [Economic Benefit? Yes Presumed Income - but rule/policy might exclude it]
1 Is this something i am getting from my own purchase?
a YES: purchase price reduction = NOT INCOME
2 Is this is something i am getting from a third party purchase?
a Getting Cash = YES INCOME
b Getting Frequent Flyer Miles = Benefit but IRS said NOT INCOME (as of now)
c Turning Frequent Flyer Miles into Cash = INCOME

13

Bargain Purchase Price


Intend to make a transaction based on what both parties thought the true value was
Ex. pay $100 for a piano, find out its worth $500k
General Rule: Bargain Purchase NOT taxable now and only taxed when sold
Exception: Compensatory bargain purchase, TAX NOW [infra below]

Realization Requirement (1001): Dont have to pay tax on increases in value until you
realize them (i.e. sell)

Two Reasons why you dont immediately tax a bargain purchase even though you have
economic benefit:
1 Valuation Difficulty: administratively difficult and onerous to require someone to get a
valuation on every purchase
Much easier to get solid number once the item is sold [need solid number for
return]
2

Liquidity: Person might not have liquidity to pay tax on the purchase, might force them
to sell it

Compensatory Bargain Purchase


Transaction is just structured like a bargain purchase
However, intent to compensate someone instead of paying additional salary
No sympathy for Valuation and Liquidity Issues
Required to do appraisal to put on tax return

61-2(d) Compensatory Bargain Purchase: economic benefit is income and taxed now
(not when its sold)

Ex. Giving bonus to employee, $100k Piano for $1.


Employee Economic Benefit (net worth increase) =$99,999
Trying to only tax on the Bargain Element: $1
61-2(d): economic benefit = 99,999 Gross Income and Taxed

Determining if economic benefit constitutes gross income:


Lottery Winner / Prize Winner

74: Prizes and Awards are Taxable


$100k lottery ticket = Windfall = Gross Income //or// Raffle Winner wins a watch
Any Reasons to exclude it?
Discrete Transaction: (not common) Taxable!!
Little Liquidity sympathy
Winning lottery enhances capacity to pay for the cost of government
14

Find Jews (Jewelry)


Common Law: have good title in the entire world except to the true owner
Reg 61-14: Treasure Trove = Economic Benefit = income!!
Discrete Transaction: No Sympathy
Liquidity: lucky to find it
Valuation: have to get appraisal for return
BaseBall
Clearly Economic Benefit - but maybe exclude?
Controversial: Buy ticket to baseball game and walk away with $100k ball - Tax Now?
Similar to windfall?
Buy lottery ticket and win $100k Windfall = Taxed Now
Bargain Purchase Price?
Paid for $10 ticket and also got $100k Ball?
Gans: More like Lottery Ticket - Taxed Now (b/c Windfall)
Discrete Transaction - Little Sympathy
If you sell baseball = definitely taxable income

1998 Service Announcement (IR 98-56): If you turn down the baseball - NO income
Rev. Rul 66-167: If you turn down economic benefit no income

If you return the baseball in exchange for gifts from the team/owner = NOW Income!!
Determined as if he sold the baseball for things of value and income on the sale - not
a gift from the team/owners
Taxpayer wants to argue they are two separate transactions: (1) returned the
baseball so no income, (2) got gifts from team/owner
Step Transaction Doctrine: If two separate transactions are sufficiently related, IRS
can look at is as if they are an integrated unit
NOT two separate transactions, but returned baseball and immediately got gifts!

Self-Created (Items / Services)


Taxed when you sell it
Dont want to discourage diligence
Privacy concerns: having to report everything you do for yourself
Valuation issues
Stock Given in Company / Free Car as incentive to take employment
Clearly Economic Benefit!
If you give the car to your Spouse?
STILL income - file joint return
If you give the car to your Daughter?

15

Assignment of Income Doctrine: Income is taxed to the person who earns it and
cannot shift it to anyone by assignment
Attempting to game the system and tax the income in daughters 10%
bracket not your 35% bracket

Landlord Renting House


Get cash money = Income to landlord
Renter exchange services instead of cash (like barter transaction) = EACH getting income
equal to rental value
Renter gives services and cash to reduce the cost:
Landlord still has income equal to actual rental cost
Person renting:
Economic Benefit = (actual rental cost) - (any cash towards rent) - (any cash
he expends to perform the services)
The hard work which the renter does to perform the services doesnt
matter
Home Ownership
Income = Consumption + Savings (both get taxed in our system)
consuming income doesnt reduce your taxable income on return

Bedrock Proposition: Do not tax imputed income from home ownership (benefit of not
having to pay rent) (Independent Life Insurance Case)

Advantages of Home Ownership


163: Mortgage interest is deductible
163(h): Only can be taken on primary and one other residence AND there is
a $1 million mortgage limit
164: Real Estate taxes are deductible
121: Can exclude $250k from income (500k if married) if selling home for a profit
Must be your primary residence

Ex: Why Renting Sucks: Two guys both make 80k a year. One has 100k in the bank and
collects 10k a year interest and uses it to rent (taxed on $80k/yr + $10k interest = 90k). The
other guy used the 100k to buy a home. (only taxed on $80k/yr NO interest).

Horizontal Inequity: If one wants to own and one wants to rent its unfair to tax them
differently.
Vertical Inequity: The more expensive the home, the advantage to the homeowner
increases and the disadvantage to the renter increases.
Distortion: The tax law is sending out a message: DONT RENT, OWN !
Ownership is good. Valuable to the economy and improves neighborhoods.

16

Owning a Car
Indep. Life Ins. applies to ownership of all assets. No imputed income from
ownership.
Might be better to buy the car than using interest from money in the bank because
the interest will be income.

Dean v. Commr: Case where guy owned stock in a corporation which owned a home that
he lived in.
Corporations are separate from their shareholders
The taxpayer has income (not an imputed benefit like in Indep. Life Ins.)
Substance over Form is a One Way Doctrine:
It can only be invoked by the IRS, not the taxpayer.
If the taxpayer chooses a bad form, tough life bro.

Final Gross Income Hypo:


Vegy grows vegetables in her garden:

Gross income?
No, not yet. This is self created property. (not taxed)
What if she sells them?
Yes, gross income. (taxed)
What if she consumes them?
Not gross income. This is imputed income from services. (not taxed)
Administrative nightmare to tax imputed income.
What if she traded her veggies for fish worth $100?
Barter transaction, both have income. (Taxed)

Chapter 3
Gifts
Consumption Model:
Multi-layer taxation / repetitive taxation
Every time you pay for something, you dont get a deduction and its income for someone
else also
consuming income doesnt reduce taxable income
Spending for personal reasons is not deductible, business reasons is...

17

162 : Business Income Model


One level of taxation / Single taxation
Allows deduction of business expenses so its only taxed once (the person getting paid has
income)

Business Expense Deduction:


Ordinary and necessary expenses paid or incurred in carrying on any trade or
business

102 : Exclusions (Gifts)


Donee receive gift, and even though its economic benefit, it will be excluded from gross
income [not a deduction]
We only tax this once, to the donor (when it was donors income.)
Exclusion is similar to 121 (supra!) $250k excluded from home sale profit
Quick Note on Gift Tax:
There is a separate tax in the code for people who make substantial amounts of gifts, so it is
taxed a second time but it is taxed to the donor again. This is gift tax, not income tax.
Gift tax looks at the gifts you made over your lifetime (not just a single gift) to
determine enhanced capacity to contribute to the government.
Triggers when cumulative gifts exceed $5 million.
Commr v. Duberstein:
Just because its a gift under common law doesnt mean its a gift for purposes of 102.
Common Law Gift: (1) Donor must have donative intent; (2) delivery; (3) acceptance
Depends on the substance of the transaction. If it was compensatory in nature, then it is
NOT a gift.

Determining a Gift under 102


Look at the predominant motivation of the transferor (Question of fact)
If it was love, affection, sympathy, detached and disinterested generosity, or a
similar charitable motive, then it is a gift.
If it was more of a business motive, or designed to compensate someone, then it is
not a gift.

18

Its a Murky Test: The transferee has to ask himself at the end of the year, what the
predominant motive was of the transferor. Transferee wants it to be a gift so it
doesnt count as income. So if colorably looks like a gift, he probably will treat it as
one.
Donor Intent = Factual Question for the Jury
The courts decision will be reviewed deferentially, not de novo, so they have
to affirm this fact finding issue; requires the finding to be clearly erroneous
to overturn.

This murkiness is bad for the self reporting system because it gives incentive
for people to not to the right thing.

Additional factors for the Jury to determine Donor Intent:


The Nature of the parties relationship (relationship based on love,
friendship, business?)
Whether the transferor took a business deduction
Court said it would not make a per se rule about taking a business
deduction, but will let it go to jury.

274 Disallowance
To be entitled to a deduction, must be able to show a section which authorizes the
deduction
Disallowance Rule: If the item is a gift to the donee under 102, then the donor CANNOT
take a business deduction.
274 (b): De Minimus Exception:
Although transferee is not reporting it as income by calling it a gift, transferor can take a $25
deduction for each small business-like gift instead of the entire cost as a business
deduction.
Once you get through 162 Business Deduction [Business Expenses on one side
(employer) - Gift on the other side (employee)] $25 Cap for employer deduction

Violation of business income model


Ex. Oil company sends calendars to #5000 clients.
We allow them to deduct $25/per because its business motivated and not really
compensatory in nature

BUT, General Rule: If its a gift in the hands of the payee, the payor cannot take a deduction.

Gans Idea: Rules are not very effective because the donee and donor are each making their own
judgment call about whether its a gift or not. IDEA: make donor send notice to the donee that they
are taking a deduction (it was not a gift - uncomfortable position)
102(c)
If an employer gives an employee something, it is automatically not a gift.
No need to worry about 274 disallowance rule
1986 Amendment to IRC adds a per se rule!

19

Goodwin 8th Cir; Rev. Rul 55-422: gifts made by congregants to the minister are not subject
to 102(c) because the congregants are not technically employers
May not deduct contributions to a person; charitable deductions are permitted
when given to an organization

Analysis
Hypo: Clients invited his lawyer to his daughters wedding. Lawyer gave a generous gift (more generous than
normal because of business relationship); does the couple have income? Can the lawyer deduct it?

Always start with Transferee perspective (Daughter):


a Definately Economic Benefit. Is there a reason to exclude it?
b 102(c): They are not employees of the lawyer. So it still may be a gift.
c Duberstein: look at the predominant motive of the transferor.

Transferors Perspective (Lawyer):


a Options: (1) Deduct $0 [b/c gift]; (2) Deduct Entire gift [b/c business deduction];
(3) Deduct $25 [b/c de minimis]
b 274: Did the transferee have a gift under 102? If they did, the lawyer may not
deduct all of it as a business expense.
i Still can deduct $25 (274 (b): de minimus exception)
c Duberstein: Makes the judgment based on his own predominant motive.
i Note: If would normally give $250 but gives $1,000 because of business
relationship. can he deduct the extra $750?
ii Murky because of self assessment. He will deduct the $750 but the couple
will likely treat the entire $1000 as a gift.

Dual Relationships
Employee is also the daughter to the employer
102(c): A gift to an employee is not a gift under 102, and counts as income to the
employee
Duberstein: One of the factors to determine the predominant motivation of the donor is the
nature of the relationship
Familiar relationship and employer relationship !!!!

Williams TC Memo 2003-97: case law indicates, 102(c) should not apply if it can be shown
that the gift was given NOT because of the employer/employee relationship, but because of
the familial relationship or some other aspect, than can get out of 102(c)
Gans: Dont want to have to fire my daughter because I want to give her a gift to help
her with a mortgage payment!

Ex. Mother-employer gives all employees a $120 case of wine at christmas. Son-employee gets a
case of wine worth $700.

20

Son-Employee-Donee Analysis: Gift?


102(c): employer-employee per se rule excluded as gift
HOWEVER, dual-relationship!! Basically two separate transactions going on:

$120 of the $700 is income because of the sons services as an employee -- every
employee got that
2 Remaining $580 ($700-$120) could be argued as a gift
It was the familial relationship (love, affection, etc.) which was the
predominant motivation for that portion
Mother-Employer-Donor Analysis: Business Deduction?
Two Transfers going on:
1 $120 to every employee
a Business Deduction - Business Expense
2 Remaining $580 to son
a Predominant Motivation for the extra $580 was love, affection, etc - Gift
$120 Deductible - $580 non-deductible
NO $25 Dollar deduction for the $580 because it was determined to be a 102 gift for
the son once it is found a gift cant now deduct by calling it a business expense

Inheritance
102: Inheritance / Bequests / Devises: EXCLUDED from gross income
Intestate: someone dies without a Will
Bequest: giving personal property
Devise: giving real property

21

Nuisance Value:
Someone with no case (a nuisance) is contesting a will. The estate decides to settle
for $10k instead of paying $100k for Trial.
Underlying claim nature is inheritance Excluded as income, even nuisance value
settlement (too complicated to create a nuisance exception)

Per Se Rule: If taxpayer was an intestate taker, any recovery he gets is inheritance

Quantum Meruit claim: provided services and expectation of compensation


Seen when two people live together and dont get married and dont have a Will.
Living person will sue the estate and could allege a Quantum Meruit claim. However
any verdict/settlement for the underlying claim would be taxed because it was
compensation for services provided (and not a gift as inheritance).

Contract claim: promise to add someone to a Will and they fail to do so before dieing
Underlying claim is relating to inheritance and any verdict/settlement will be seen
as a gift

When both Contract claim and Quantum Meruit claim are alleged, and none have been
dismissed, Contract claim is more important, and any verdict/settlement will be based on it
for income determination

Ex. Attorney renders services for chicks divorce in exchange for bequest of certain stock in Will when she
dies. Income to Attorney? [Post-Duberstein]
Predominant Motivation in giving attorney the stock?? [ 102 - Duberstein]
Found: Compensation for services = Income, NOT gift

SCPA 2307: Executor entitled to commission for services rendered as executor and it is a
percentage of the estate

Merriam Case: In Will, I bequeath the sum of $20,000 to my friend John in lieu of all compensation
for the services he renders as my executor.
Compensation and Income - or - Bequest and NOT income?
Predominant Motive: Services
Language: Bequest
Treated as Bequest because of the language

Potentially Narrow Proposition: Merriam Case (PRE-DUBERSTEIN but not overruled)


Bequeath to this person a sum of money in lieu of compensation - might still be
excludable as bequest
Not good language to use

Settlement Agreements
Settlement Agreement is taxed the same as you would a recovery on the underlying claim,
no different if a court verdict

Tax consequences will depend on the nature of the claim asserted:


Contested Will: 102 - Inheritance NOT taxed
Tort and Damages: Personal Injury NOT taxed
Contract Dispute over salary due: Taxed

State Law Issues: State created labels / views of income


IRS only interested in Substance of transaction
State law labels are not determinative

Hypos on P.66-68

Chapter 4
Adjusted Gross Income (AGI)

22

Deduction versus Exclusion


Deduction is applied above the line or below the line
Taxpayer deducts certain money he paid
Exclusion reduces Gross Income right from the start
Taxpayer excludes certain money he received.

Two Categories of Deductions:


Above the Line:

62: Adjusted Gross Income: List of what deductions you can take Above
the Line. (Gross Income) - (Some Deductions) = Adjusted Gross Income
Includes: Business Expenses of a Non-Employee
Ex: Sole Practitioner / anyone without a boss

Below the Line:

63: Taxable Income: (Adjusted Gross Income) - (Some Deduction) =


Taxable Income
Taxable Income used on Rate Charts to determine tax $ owed

Generally: Mortgage Interest deduction on home ( 163); State and Local


Real Estate Taxes on home ( 164); Charitable Deductions ( 170); Medical
Expenses, Casualties (fire, theft)
Business expenses of an employee

Below the Line: Can Take either:

Standard Deduction: Automatic, dont have to show paid x for this,


IRS just gives it to you
(2013, joint return was $12,200)
Takes low income taxpayers out of the system (people who
cant afford to contribute to the cost of gov.)
Eliminated the need for bookkeeping which is needed for
itemized deduction

Itemized Deductions
If your expenses are above the standard deduction amount,
prefer itemized
Required to prove you are above the standard deduction
amount and list each expense
[Income Tax return 1040 Schedule: lists itemized
deductions]

Analysis:
1 Calculate Gross Income (accounting for any proper Exclusions)
2 Subtract 62 and other appropriate Deductions
3 Calculate Adjusted Gross Income
4 Decide if you want Standard Deduction or Itemized Deduction
5 Calculate Taxable Income

(Example on Next PAGE)


23

Ex. Sole Practitioner makes $100k, pays secretary $50k. Taxable Income for Lawyer? [Assume SD = $11,600]
a Gross Income $100k
b Any Deductions?
i
162 Business Deduction permitted
ii Applied Above the Line or Below the Line?
1 62: non-employee expenses (sole practitioner = has no boss; if he was an
associate it would be employee expense and below the line)
iii Salary of secretary is applied Above the line
c Adjusted Gross Income = $50k ($100k - $50k)
d Below the line deductions?
i
No other deductions in hypo
ii Choose to take Standard Deduction $11,600
e Taxable Income = $38,400 ($50k - $11,600)

Medical Expenses

213: The first 7.5% of your Adjusted Gross Income is essentially a haircut on your
medical deduction
Ex. $100k AGI; Medical Expenses $10k. 7.5% of $100k = $7,500. First $7,500 is
income, anything remaining is deductible = $2,500.
Reason for Haircut: Involuntary medical expenses affect the ability for the taxpayer to
contribute to the cost of government
A lot of medical expenses viewed merely as consumption
Used for unfortunate, serious and extraordinary medical expenses
Medical Expense Deduction applied Below the Line

Business Expenses of an Employee

Below the line deduction is not necessarily going to pan out into tax savings. May not have
value if you choose to take the standard deduction.

Ex. Law School says they wont pay for JIBL or AZTECH so Professor pays it himself for $1,000.
a Deduction?
i
162: Business Expenses
b Above the Line or Below the Line? 62
i
Since Professor is an employee goes Below the Line
ii If he was non-employee Above the Line
c Standard Deduction v. Itemized?
i
Applied Below the Line: Will use Standard Deduction! No tax savings.
d MORE likely to ask the Law School to pay him $99,000 and $1000 for the stupid shitty
Journal!!!
i
Journal $1000 could then be excluded from professors income as Working
Condition Fringe (Infra) [Straight $1k off Gross Income]

24

Employee v. Non-Employee Expense


If you are an employee and your employer hasnt provided something for you and
you buy it on your own, the code is suspicious/skeptical, if your employer didnt
give it to you you might not absolutely need it for the job.
If employer provides it, not skeptical, and you are NOT taxed on it

Non- Employee expenses goes Above the Line

Employee Expense goes Below the Line, and must be itemized if you want to claim a
deduction greater than the Standard Deduction

67 [Code Amended]: Employee Business Expenses:


Categorized as Miscellaneous Itemized Deduction, so only get the benefit if you
itemize deduction
2% of Adjusted Gross Income haircut on total Miscellaneous Itemized Deduction

Ex. Professor again; AGI $100,000; All of the employees business expenses: $1,000 JIBL & $500 ACTEH, $500
Conference = $2,000.
a AGI: $100,000
b Deduction? 162 Business Expenses
c Above or Below the Line? 62 Employee Expenses Below the Line
d 67 Employee Business Expenses: Miscellaneous Itemized Deduction
i
2% of $100,000 = $2,000
ii Can take deduction on anything over $2,000
iii Professors total expenses were only $2,000
e NO deductions!!! Only paid $2,000 and no Expenses over that to get deduction!
f
Paying tax on $100k AGI and also had to pay $2,000 for expenses!
g Like Above: Better to work with law school to get less salary and have them pay for expenses
so they are fall into Work Condition Fringe, and get excluded from Professors Gross Income

Fringe Benefits
Fringe Benefits:
Something you get from employment relationship over and above salary
Ex: Frequent flyer miles
Not a gift because of 102(c) [employer to employee] but can still exclude from employees
GI

25

132: Certain Fringe Benefits


If you get a fringe benefit of the type described in this section from your employer,
you may exclude its value from your gross income.
132(a) Categories
Working Condition Fringe Benefit
No Additional Cost Fringe Benefit
Qualifying Nature Discount
De minimus Fringe
Qualified Transportation Fringe

26

132 (a)(3): Working Condition Fringe


Anything provided to an employee by an employer if the employee would have been
entitled to a 162 business deduction had the employee paid for it himself.
(Ordinary and necessary expense to carry on business)

Ex. Plumber gets a new set of tools from his employer


Its difficult to determine economic benefit because he may not want the
tools but needs them to do his job better. (Very Subjective)

Exclusions enjoyed disproportionately by high level employee


Ex: CEO in a big nice office, flys around for business in a private jet. Great
benefit, but still working condition fringe because he would be able to
exclude it as a business deduction had he paid for it himself.

132 (a) (1): No Additional Cost Fringe Benefit


Situation where there is no additional cost to the employer for providing the benefit.
Ex: Airline allows flight attendant to fly for free when there is a vacant seat.
(No Cost to the airline). Attendant can exclude this from gross income.
Excess Capacity Fringe
If they had to bump a passenger, no exclusion under 132.
Spouse, kids, etc. OK so long as no additional cost (bumping passenger/canceling
someone elses hotel room = lost $$ = cost!)

This exclusion is not available to high level employees, UNLESS it is available


throughout the company on a non-discriminatory basis.
Ex: Pilots fly free if there is a vacant seat but flight attendants have to pay
50% of cost. The policy is OK but the pilots wont have an exclusion under
132.

Anti-Conglomerate Rule: Only get exclusion for the no additional cost service fringe
or qualified employee discount if item you are purchasing is in the same line of
business that you sell for the company

Qualifying Employee Discount Fringe


Allows employees to exclude discount benefits from their income
Must be non-discriminatory between high and low end workers
See Anti-Conglomerate Rule: [Above]
Exception to compensatory bargain purchase
Ex: Store sells item for $100 but allows employees to purchase for $75.
Employee had $25 of economic benefit but it is excludable as a qualifying
employee discount fringe.
132(c)(4): NOT available with respect to real estate (real property) and not
available for personal property of a kind held for investment.

If employer sells to the employee such that the price is less than their cost
INCOME to employee is difference between employee price and employers cost
Look at profit markup for the entire year.
Ex: Company bought $1 million in goods and had $2 million in profit. 50%
profit and 50% cost, so they can give their employees a 50% discount
without them having any income.
Company has 50% cost. Item normally sold for $100 but they sell to
employee with a 70% discount. Employee has $70 economic benefit
but only $20 will be income. [employee paid = $30; employer cost
$50]

De Minimus Fringe
Things that are low in value and not worth keeping track of.
Requirements: Low value, traditional, holiday/birthday, and NOT cash
Ex: Employer provides coffee. Employer is going to deduct this and the
employees are going to exclude it as a de minimus fringe. We tolerate this
violation of the business income model.

Often used to deal with odd-ball situations.


Ex: Employee using work cell phone for personal (1-800-sexline) calls. [IRS
Notice 2011-72]

27

Service Company Discount:


Employee can exclude up to 20% discount from their service
company. (First 20% tax free)
Ex: $100 Service gives employee 30% discount. Employee
has $10 of income.

Ex: Allows occasional overtime meals to be excluded, when provided


because employee is working overtime.

NOTE: 102(c) prevents employer-employee gift exclusion Since outside of 102


NO $25 minimum employer deduction under 274, and employer can deduct
TOTAL cost as business deduction For employee: if it fits into the De Minimus
Fringe requirements employee can exclude.

Qualified Transportation Fringe


Rev. Rul 99-7: Cost of commuting to and from work is NOT deducible.
It was your decision to live far from your workplace bro.
If employer reimburses you for commuting, that is income.

Driving for a business need is qualified (not commuting).


Ex: Lawyer drives to work, not excludable. But when he has to drive to the
court for a client and then back to work, that is driving for a business need
and is a qualified transportation fringe.
When firm reimbursed the lawyer, it is excludable.

When employer pays for parking


Can exclude up to a certain maximum the value of parking under this fringe
($240 per month), the rest counts as income to the employee.
Some people dont like this because it discourages mass transit. So...

Amended to include value of transit passes


So if employer pays for your transit pass, you can exclude it [up to $125 per
month]
CANNOT give you cash, must actually give you the transit pass

NO non-discrimination requirement between high and low employees

119: Meals and Lodging Provided by an Employer


Not all fringe benefits are under 132
Requires non Discrimination between high and low employees

Lodging Requirements: (1) the convenience of the employer; (2) required to use it as
condition of employment; (3) it must be on the business premises of the employer
Employer can only give the employee the right to use the property, NOT title

Meal Requirements: (1) convenience of the employer; (2) business premises requirement
Gans doesnt think theres really a difference.
Ex: Maid/Butler/Chef who lives on the premises and gets free lodging and meals.
Note: Just because the employment contract has a clause saying that lodging is a
condition of employment doesnt mean it qualifies under 119. Provisions will not be
determinative (substance over form)
Dobbe: TC Memo 2000-330: Groceries do not qualify for excluded meals under 119. If
employee gets whatever groceries he wants, that is income. No coercive effect from
employer since employee is making the decision. If employer buys the groceries and
employee has no choice, then probably 119 exclusion.

Hypos on P.80-82

28

Herbert Hatt Case: Dude had a funeral home, he lived there and worked there. He
incorporated it and claimed lodging and meal exclusions under 119. It was allowed,
although it violates substance over form because if he didnt incorporate he wouldnt have
been an employee and would not qualify for 119. (form over substance!?)
Tax laws buy into the corporate fiction that a corporation is a separate and distinct
entity. The IRC will respect the fact that if you work for your own corporation youre
an employee.
Hatt could now pay the residence portion of utility bills and for his personal meals
with the corporation. The corp would take a business expense deduction and he
would exclude his personal benefit from his gross income. This is a violation of the
business income model.

Commr v. Kowalski: State troopers were provided a cash reimbursement for their meals.
They tried to get this excluded under 119.
Supreme court held that there is a difference between the use of the word meals
and cash reimbursement and construes the term meals narrowly.
meal: meal provided in kind, not a cash reimbursement for a meal
Rule: 119 does not apply when employer provides reimbursement for meals you
had over time.

66-94: Imposes civil penalties on preparer of return (advisor) for taking a position without
sufficient foundation.
Circular 230 (10-34): same as 66-94, civil penalties and violations, can result in disbarment.

Chapter 5
Prizes and Awards
74 Prizes and Awards:
Prizes and Awards constitute gross income. (Economic Benefit)
Prior to 74 taxpayers have argued it was a gift under 102 and therefore excludable from
gross income.
Ex: Prize on a game show, the predominant motivation is business reasons,
therefore seems like a gift under 102. However, now 74 is a per se rule that does not
allow the gift argument for prizes and awards.

29

What if you want to give award to a charity?

170: Charitable Contribution Deduction: A below the line deduction with a limit
on how much you can deduct. A person cannot deduct more than 50% of their AGI
under this provision in any given year, the excess is carried over to the following
year for up to 5 years.

Hypo/Problem: AGI is $50,000; award is $100,000; so now AGI is $150,000. This


person is only allowed to deduct $75,000 (50% of AGI) as a charitable contribution
even though they want to donate the entire $100k award to charity.

Rule: Code says that the 50% rule from 170 does NOT apply if giving an award
directly to charity. (Avoids the above problem)
Must go directly from organization giving the prize to the charity, cannot
accept the award then give it to charity yourself.
Remember: Only the government can make a substance over form
argument. Taxpayer must be careful here.

Employer awards employee with a business trip


132 Working condition fringe OR 74 Prize ?
It doesnt matter how the employee got selected, it is still a working condition fringe
even though it feels like an award.

274(m)(3): Employer cannot take a business deduction for the cost of sending his
employees wife on the business trip with him.

Education

Generally: Education is treated as Consumption - NOT deductible as a biz expense


Argument for tax relief: Huge school bills affect ability to contribute to the cost of
government
However, not much sympathy for professional school bills (will have lucrative career)

Scholarships

30

117: A student who is a degree candidate can exclude a Scholarships from income (per se
exclusion)
1986 Amendment: Removed the Room and Board exclusion ONLY exclusion for
Tuition (1986 - widening the base to lower taxes and removed some exclusions)
117(c): If you are getting a scholarship in exchange for past, present, or future
services rendered that portion is NOT excludable and constitutes income

Ex: School gives $10,000 of scholarship, but $5,000 is room and board and $5,000 is for
tuition.
Only the tuition portion is excludable.

Ex: School gives $10,000 of scholarship but requires $1,000 of services (work in library)
The services portion is not excludable under 117. ($9,000 excludable)

117 Scholarship trumps 74 Award: Winning an education stipend


Outside of employer-employee situation, no compensatory nature, not working for
people granting the stipend
Employer-Employee Situation: Had 117 (Scholarship), 127 (employer
provided education), Working Condition Fringe
Outside Employer-Employee Situation: 117 and 74 (Prize and Awards)

General Rule: Prizes and Awards are Income


74: except as otherwise provided in section 117, prizes and awards are gross
income
117 Controls!!
Substance: stipend is a scholarship, the fact that you win it as a prize is not
substantial enough to remove it from the 117 exclusion.
Similar to winning a business trip when the selection process is done via
raffle. Substance is a working condition fringe, even though you won it.

Athletic Scholarships

31

Rev. Rul 77-263: Athletic Scholarships are NOT income and are excludable
Seems like compensation for services, but not income

STILL excludable if:


Contingent on GPA
Student doesnt play for a particular year and he is still given the scholarship for that
year
Student gets a free ride for the first year but doesnt play and the scholarship is
taken away after the 1st year

Problem which will create INCOME:


School tells the the student the scholarship will be taken away if he misses one game
or taken away within the 1st year

Scholarship provided by the School to the children of Schools Employees


Gans daughter gets free tuition because Gans is a professor
117(d): These kinds of free tuition for employees are not taxable and are excluded from
income
Same principal as the free airline seat provided to employees - excess capacity
MUST be nondiscriminatory to be excludable
Includes Professors, Secretaries, Janitors (Joe Dirt), everyone!

Reciprocal Plan: Employers can set up reciprocal plans with other employers, so that the
employee of 1 school can send his daughter to a reciprocating school for free and still
exclude the cost of the tuition.

Cost of Education as a Business Expenses


NO deduction if the education you are pursuing is the minimum amount required to get into
that business
Education must be for the purposes of carrying on a trade or business [162 Business
Expenses] [Regulation 162-5]
If the education paid for by student/taxpayer qualifies as a Business Expenses for them,
student/employee could get Working Condition Fringe if the employer payed for it.
Cant be general college education
Must be specific enough to hone your particular business skills
Examples:
Law Student cannot deduct the cost of education as a business expenses
NOT yet carrying on a trade or business required under 162: business deduction

32

Solo practitioner paying for a $2,000 course in tax law = Deductible business expense.
Carrying on his business and incurred the expenses to hone his skill
Deductible Above the Line because he is a non-employee.

Gans paying for a $2,000 course in tax law and Employed of Hofstra. Deductible business
expenses for Gans.
Carrying on his business and Gans incurred the expenses to hone his skills.
Deductible Below the Line because Gans is an employee
Requires itemized deduction
Subject to 2% haircut rule

Hofstra pays for a $2,000 course in tax law for Gans. Deductible business expenses for
Hofstra, Working Condition Fringe for Gans. (Money disappears from tax system)
Hofstra: gets a business deduction because they are carrying on their business by
honing their professors skills.

Gans: gets to exclude this as a working condition fringe because he would have been
able to take a business deduction had he paid for the class himself.

Bar Prep Cost:


Law School Graduate has now acquired new business by graduating
However, you still have not passed the acquisition phase to carry on business as a
lawyer [need to pass the bar with license!]
NOT deductible

LLM course after graduation?


Still not carrying on if you go right into an LLM course after graduation
Carrying on if you graduate, pass the bar, and work for employer to hone skills
Would satisfy 162 Business Deduction
IF EMPLOYER PAID:
Employee could take Working Condition Fringe

Employer pays for bar prep course to all new associates (nondiscriminatory).
Employee: CANNOT qualify for 117 Scholarship - Required to be in pursuit of a
degree - License is NOT the same as a degree (ALSO if required to work would be
seen as compensatory and not scholarship)
Employee: NO working condition fringe - Employee could not get 162 Business
Deduction if they had paid it himself
127: Can exclude $5250 [INFRA]

127: Employer Paying for Education


If your employer pays for your tuition, on a non-discriminatory basis with a written plan,
then you can exclude up to $5,250 of this from your income per year.
Ex: Employer gives $10k for tuition, written and nondiscriminatory. You can
exclude the first $5,250 and the rest ($4,750) is taxable income.

Chapter 6
Gains from Dealing in Property
Basis
61(a)(3): Gross Income includes Gains derived from dealings in property

33

1011: How to Determine Basis (Return of Capital)


Basis Principal Function: permit taxpayer to recover a return of capital, tax free: if
simply getting back your cost, no economic benefit and no gross income

1012: Deals with Purchases; Basis = Cost

Realized Gain/Loss

1001: How to compute gain/loss


Amount Realized (AR) - Basis = Realized Gain (RG)
Amount Realized = Essentially the sale price
The sum of money received plus fair market value of property other than
money received on the disposition.

Realized Gain = Recognized Gains


Except as otherwise provided, all realized gains are to be recognized
Ex. Gift Exclusion, Fringe Benefit

Loss:
When 1001 computation shows a loss, you dont automatically get a deduction.
1001 only gives a computation and doesnt authorize a deduction.

165 Deduction on Loss:


Must be: (1) loss incurred in trade or business; (2) loss incurred in a
transaction entered into for profit; or (3) casualty loss.
Code doesnt want to permit deductions for consumption
Ex: Bought suit for $1000, sell for $100. Basis is $1000 and Amount
Realized is $100 (Loss of $900). Suit is not trade or business. We
dont allow a deduction because this was consumption.
Ex 2: Same as above but stock in a company rather than a suit. This
is now an investment and we would allow deduction of the loss
under 165.

Note on Casualty Loss: Can only deduct the casualty to the extent it
exceeds 10% of AGI
Ex: AGI is $ 100,000. Your $40,000 car fuckin explodes. You
can only take a loss of $30,000. (10% of AGI is $10k, $40k $10k = $30k)
The code relates the loss to your income to assess your
ability to contribute to the cost of government.

No Deduction for Loss on Home


Cannot take deduction for loss on the sale of a home under
165. Although it is arguably a transaction for profit the
code doesnt buy it.

34

Exception: If its a home that you purchased to rent out for


profit. (More like an investment). Conversely, now the 121
deduction is not available (supra/ $250k exclusion)

Concept of Deferral

Not taxed right away, carries over until you sell.


Ex: A Bargain purchase is taxed when you sell it. (Deferred)

Taxpayers love deferral because it has economic value by giving the taxpayer the
opportunity to earn money/interest on money that would have gone to the IRS.

Taxable Exchange

Giving up one asset for another. Taxpayer wants to enjoy the continuation of the deferral.
The code doesnt allow this and it is taxable on the spot.

Generally exchanges are taxable. (The realized gain will be recognized.) (Barter)

Ex: Trade $500,000 worth of stock for $500,000 shopping center. (Bought stock a long time ago for
$1000 so basis is $1000). The taxpayer was enjoying the deferral on the stock all these years, and
wants to continue to defer the tax until he sells the shopping center. The code says no! This is a
taxable exchange and his realized gain ($499,000/ value of shopping center) will be recognized
(taxable).

How to Deal with Basis:


1
2

Function 1 of Basis: return of capital investment


Function 2 of Basis: If you receive some kind of non-cash asset, and you recognize a gain on
that asset, then you can increase your basis equal to that recognized gain [Function 2 Basis
Step-up]
a Receiving cash No Basis concept for your cash [just income]
i Foreign Currency might have basis
b The Step Up: Add back in the amount of recognized gain

When you do a taxable exchange [i.e. you can calculate realized gain and therefore pay tax
on that amount] your basis in the newly acquired asset is equal to the fair market value

Peel Rule:
Calculating your Basis in the received asset when you do an exchange and have a Deferral
No Recognized Gains (Ex. Dont know value of either asset - Philly #3; 1031 Exchange INFRA!!)
When you acquire land for $100, lets say you put a note on it indicating the basis of
100

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When you do Philly Rule #3 Deferral you peel the note off the asset you
originally had and attach it to the new asset which you received [Same applied for
1031 Exchange]

Philadelphia:
Exchanges are generally taxable, but on occasion there might be a nontaxable exchange
1012: when you purchase an asset its basis is equal to cost
1001(c): all realized gain is to be recognized gain except as otherwise provided
Recognized Gain: realized gain which gets added to gross income; some code
sections provide exceptions which will prevent realized gain from being recognized
gain
When you qualify for a 121 exclusion - it is permanent - NOT a deferral

Rules for Taxing Exchanges


[Determining Amount Realized & Basis]
3 Rules of Philadelphia:
1

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[KNOW VALUE OF BOTH] Basis in newly acquired asset is equal to the fair market value of
asset received
a Dont want to double tax on same gain
b Accounted for any gain recognized already stemming from the transaction and paid
tax on that, so now your basis in the new asset accounts for that
c Function 1 and Function 2
[DONT KNOW VALUE OF ASSET BEING RECEIVED] If you dont know the value of the
asset received, the value of asset received is equal to the fair market value of the asset given
a Need to think about the amount realized of received asset; if receiving a painting
and dont know value, infer the value is equal to the value of real estate which is
being given
b Use this assumed amount realized to calculate your realized gain from the
transaction
[DONT KNOW VALUE OF EITHER ASSETS] If you cannot determine the value of either
asset, cannot determine amount realized, will not tax the exchange!! Allow you to defer the
gain!!! [PEEL Rule Applied]
a Taxed when you sell the asset you received -- accounted for when you can
determine an amount realized from a sale to someone else [occurring after the
original exchange]

1031: Exchange of Property for Investment


If you do a like-kind exchange, meaning the two assets (one given and one received) are of a
similar quality, and the assets are being used in trade or business or as an investment, then
there is no recognition of gain on the exchange - TAX FREE [PEEL Rule Applies to determine
your basis in the new asset]
ONLY asset used in trade, business, investment
NO securities exchanges (stocks)

With Real Estate: requires a Qualified Intermediary if the owner of the property you want
doesnt want to exchange for your property but wants cash!!
For a fee: a third party buys the property you want from the original owner who
wants cash not trade, and then exchanges with you under 1031, than third party
sells your original party

Example 1:
Farmer 1 wants to exchange land with his neighbor, Farmer 2; Exchange Taxable?
Farmer 1 paid $100 for his land = Basis in his original land
Farmer 2s land value being exchanged = $500 = Amount Realized
Amount Realized - Farmer 1 Basis = Farmer 1s Realized Gain
$500 - $100 = $400 Realized Gain to Farmer 1
1001(c): All Realized Gain = Recognized Gain unless exception applies
NO Philly Exception: Know Value of Each Asset
1031: LIKE-KIND exchange !!!
1031 permits tax to be deferred
Farmer 1s Basis in his new asset??
PEEL Rule: Because of 1031 Deferral, No Recognized Gain during Exchange
Peel his $100 Basis and put it into New Asset
Example 2: Real Estate Investment
Own a shopping center in NY and want to buy one in FL
NY shopping center cost $100k = Basis in NY shopping center
FMV = $1,000,000
If straight up sale: $900k Realized Gain
Find Florida shopping center with FMV = $1,000,000
Setup 1031 exchange!
Like Kind exchange of asset used for investment
No Recognized Gains = Tax Deferred
Peel Rule: Carry over $100k basis from original NY shopping center to florida shopping
center

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GET OUT OF REAL ESTATE AND STILL USE 1031


You want to get out of real estate investment, but dont want to pay the tax if you
straight up sell the property
Long term lease with someone (ex. CVS) and they pay your monthly rent in cash,
instead of interest you would have gained by investing the straight cash.

Boot

You can do a 1031 exchange to get a piece of property that CVS wants to escape
paying tax while also getting rent payments!
NOTE: still paying tax on the income from rent payments!
In reality: you have a piece of paper - promise from CVS to pay rent - not property

Borrowing Money to purchase :


Crane Case: if you agreed to pay back a loan then we are going to assume i will pay it
back: if i take on debt to buy an asset, it is viewed as my money
Ex. Purchase for $10,000. Borrow $2,000 and pay $8,000 cash. Basis?
Basis: $10,000.

Exchanging property and one person is getting extra cash on the side because the fair
market values are different [real world situations]
Receiving cash does not qualify as a like kind property under 1031
Separate and tax the cash portion while the land exchange gains a 1031 deferral
Dealing with boot - In non-recognition model:
The amount of gain recognized is equal to the lesser of: (1) the realized gain;
OR (2) the amount of boot received

Analysis: GAINS AND BASIS ARE TWO SEPARATE ANAL-SEEDS!!!


1 Need to calculate the realized gain and recognized gain
2 Need to calculate the new basis in the property you receive
Example:
Josh wants to exchange NY property with Robs Florida Property:
Josh: FMV=$110; Basis=$105.
Rob: FMV=$105; Boot: $10.
How much gain does Josh Recognize? What is Basis in new property?
(1) Recognized Gain:

(2) Basis in New Property?

Amount Realized: $100 + $10 = $110


Basis in NY property:
- $105
Realized Gain:
$5

Function 1: [PEEL RULE]

$105

Add (any new cash added)


Subtract (any cash taken)

+ $0
- $10
$95

[BOOT RULE]: ($5) v. ($10) =


[Any Exclusions?]
Recognized Gain:

$5
$5

[Tax Paid on $5 Now - economic gain]

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Function 2: (Add Basis Increase)


(Amount Realized):

+ $5

New Basis in FL Property:

$100

MORE Basis Hypos p. 108-110


1016: Adjustment to Basis
Basis is upwardly adjusted if you put more capital in
Ex: Extension on House. $10,000 Basis in a house. You add $2,000 and build
extension. New basis = $12,000.
(Also says depreciation lowers basis, infra)
Blatt Blatt Blatt! : Tenant build structure on your land. Income?
Case: Rented land on which tenants built movie theatre.
Held: Not Income. Defer in effect. Do not want to deter this. It will be taxed when sold. Basis
remains what it was.

109: Even when the lease terminates, its still not income. Will be taxed when its sold.

Supreme Court Intent Question: Was the improvement intended as additional rent or was it
more in the nature of something the tenant wanted. (now adopted in reg. 61-8(c))
Dont want to let Blatt rule exploit barter situations
Ex: Build a movie theatre on my property, use it for 5 years and I wont charge you
rent = INCOME! Taxed now, no deferral.

Note: Draft a good lease! Language should say any structures built are to facilitate
tenant business and is not intended as rent.
Gans: Intent allows taxpayers to play with issue and avoid the income
outcome.

IRS Estoppel Argument


Ex. Find a diamond in the street worth $10,000. Income! Economic Benefit, etc! Pay taxes on
it. Basis = 10,000 (Function 2 step up). BUT what if you never paid taxes when you found it?
IRS cannot audit the earlier return because there is no fraud so 3 yr SOL.
However, IRS can successfully argue estoppel from saying your basis is $10,000 since you
never paid tax on it.

39

Ex. Basis of Compensatory Bargain Purchase Transaction:


Paid $1,000 for Piano worth $100,000 from my employer in exchange for work.
Compensatory: PAY TAX NOW on Income - $ 99,000
Basis in Piano = $100,000 [Already paid tax]
Once you say you show income - Function 2 Basis step-up: showing you how that
income has to trigger step-up or you will be taxed twice on the same income
If you don't report the income (ex. finding a diamond ring on the street and not
reporting it) you cannot get basis step-up when you go to sell it and price has gone
up

Example of Basis Working with Other Rules:

Buy a painting that retails for $10,000


Used employee discount and got it for $9,000
What is your basis?
132 Qualified employee discount: essentially cant be an investment

If Painting is an Investment: 132 doesnt apply and need to recognize 1,000 of income.
Function 1 = 9,000
Function 2= 1,000
Basis = 10,000

If Painting is NOT an investment: 132 applies. No income.


Function 1=9,000
Function 2= 0
Basis = 9,000

Basis in Gifts
1015: Basis of Property Acquired by Gift

(The Gift Model codified Taft v. Bowers)

The gain that accrued on the donors watch shifts to the donee.
The donee recognizes the gain when its sold. (Not when received! - 102)
Donees basis = Donors basis.
Basis remains permanently fixed to the asset when gifted. (sticky note).

Hypo: Gans has an asset he bought for $ 1k (basis) and now its worth $ 2k. He shifts it to his
daughter-- not income to daughter ( 102). What happened to the $ 1,000 of gain? Does it
disappear? Tax to Gans when he makes the gift (like a sale)? Tax to daughter when she
sells?
1015: Donee basis = donor basis
Tax to daughter when she sells. (Her basis = $ 1,000)

We allow Gain shifting, but not income shifting.


Ex: Income Shifting. Assignment of Income Doctrine: Gans cannot assign his salary
to his daughter. Hes trying to game the tax system b/c daughter is in lower bracket.

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Reason: We dont want to permit disappearing gain.

We dont care about Gain shifting because most gain that one has from selling an
asset is Capital Gain which has a max tax rate of 20%. People cannot shift capital
assets to lower their marginal bracket. (As seen with income shifting).

Gain Shifting when Sale is Imminent.


Ex. Instead of Gans selling his house and raising his marginal tax
bracket, he decides to gift it to his daughter and have her sell it
immediately. (Sale is imminent).
Substance over form
Step Transaction Doctrine
IRS will probably prevail if the sale was fairly
imminent.
removes the daughters step and treated as if Gans
sold it directly

Transfers Between Spouses


Farrid and Davis Cases: p. 118 - 120
1041: Transfers between spouses qualify for the gift model
Husband and wife are treated as one economic unit
No gain recognition even if the wife gives the husband valuable consideration in exchange
for the transfer
NO recognition of gain to transferor and basis transferred:
Transferee steps into the shoes of transformer
Designed to overrule Farrid and Davis
Failed to overrule Farrid!! (Farrid-transfer made when they werent spouses or
former spouses)
DIDNT address the prenup situation (Farrid)
Overruled Davis: fixed divorce situation
Hypo: What happens now in Farrid Situation?
Transfer made before marriage Might Have Gain!
Advise Client: Wait until you are married for transfer to qualify for 1041!!!
1041: NO GAIN Recognition! Basis Transferred!
Draft Anti-nuptial Agreement: Give asset in exchange for release but my obligation to do so
only becomes effective at consummation of the marriage
Considered married so falls under 1041!!
Even without the recommended language in anti-nuptial: Some states view the parties as
having intended to make the transfer when the marriage occurs
DOMA
For all federal purposes (including tax) same sex marriages are treated as not-marriages
1041 CANNOT APPLY
Back in gain recognition situation

41

HYPO:

Examples
1041 Today: Husband and Wife Getting Divorce

Husband and Wife are getting a Divorce. Asset A: FMV $1,000,000 - Basis $0. Asset B: $1,000,000 - Basis:
$1,000,000. Husband has title to both. Husband wants to give an asset to wife in exchange for a waiver of her
rights.
Representing Husband: Husband owns both assets and wants to make the transfer
Husband gives Asset A (FMV: $1,000,000 with $0 basis) to his Wife
1041 NO gain recognized
Representing Wife: Gets Asset A in exchange for waiver of rights
Asset A carries over the Basis of $0 to the wife!
When she sells, she will have huge gain ($1,000,000)
She thought she was getting a 50-50 split of the assets and both were walking away with
$1,000,000! WHEN SHE SELLS SHE WILL GET BENT OVER!
Whoever gets the asset with basis of $0 needs to get compensated for taken on that liability
For Divorce Lawyer: Two Columns for each asset - (1) FMV (2) Basis!!
Two Consequences of Gift Model
1 Transferor recognized no gain

Basis is permanently attached to the asset


AFTER HYPO:
Cash Purchase Between Spouses

Wife: Asset with Basis of $1,000. Husband buys it from the wife for $7,000 in Cash.
Husbands Basis?
Under 1041: Subject to Gift Model
Wifes basis is carried over with property = $1,000
How Much Gain Does Wife Recognize?
1041: NO GAIN recognized

ALL DAY:

Taxable Exchange Between Spouses

Two Assets both worth $1,000,000. Husbands Basis - $0. Wifes Basis - $500,000. Agree to exchange.
Husbands Recognized Gain?
Acquired an asset with $1,000,000 with a Basis of $500,00 in exchange for an asset with
$1,000,000 and a Basis of $0.
Has Realized Gain But does it become recognized gain?
Taxable or does any rule permit tax free exchange.
Feels like spouse could apply ( 1041) NO gain recognition = gift model
ordinarily this would be taxable exchange (1,000,000 - 0 = 1,000,000) but 1041
prevents it from becoming recognized gains
Husbands Basis in new asset?
1041: Basis is attached to the asset when exchanged
Husband got Wifes asset which had a basis of $500,000.
Husbands Basis in the new asset = $500,000
Wifes Gain?
Realized Gain ($1,000,000 - $500,000 = $500,000) but 1041 cuts it off
NO Recognized Gain
Wifes Basis in asset received?
1041: basis is attached to the asset during exchange
Wife gets basis of the asset which she received = $0 (The Basis which Husbands asset had)
Wife is pissed off: lost her $500,000 Basis and received an asset worth the same as what she gave
up!!

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Like-Kind Exchange Between Spouses (1031?... Nope! 1041)


Real Estate for Real Estate (like-kind) both held for income productive purposes (investment /
business) 1031 or 1041?!!!
Treas Reg 1041-1(T)(a)(2): 1041 Controls!!
Both 1031 & 1041: NO Gain recognition
Basis Calculation would be different.
1041: basis is attached to the property during exchange
1031: peel rule! each person peels their basis and attaches it to the new
assist they receive.
Prevent intact married couples from choosing 1031 (so one person could can peel off a
high basis onto a previously low basis asset during an exchange) and then sell the asset
using the basis to reduce recognized gain.
Hypos: p.125 - 126
Anti-Cherry Picking Rule
1211: Limitation on Capital Losses (Anti-Cherry Picking Rule)

All capital losses can only be deducted to the extent that you recognize capital gain that
year. (Usually will be stocks).
Capital Losses are deductible ABOVE THE LINE
Two Exceptions:
De-minimus Rule: Can deduct up to $3,000 even if no capital gains. (Can go
against ordinary gains)

Can carry over loss into future years indefinitely: Until there is capital gain
to deduct from, and deduction is used up.

1211 Defines the terms capital gains and capital loss

Analysis: Want to deduct a loss?


1001: Calculate Loss
165: Is it Deductible?
1211: Limiting Capital Gains Losses
Carry over any remaining Capital Losses

Hypo: Capital loss of $100,000.


Capital Gain of $ 20,000. Now can deduct $20,000 of losses and carry over the $80,000 of

43

loss until next year.


Next year there is $ 0 gain. Can deduct $3,000 (de-minimis) and carry over the $77,000 loss
until the next year.

Exception to Gift Model: Losses

Gift Model ( 1015): Basis = remains permanently attached to the asset.


Anti-loss shifting is an exception to the Gift-Model.

Anti-Loss Shifting Rule:


Losses accruing during the donors ownership of the asset cannot be shifted to the donee.
This Rule Deals ONLY WITH LOSSES. We allow gain shifting.

1st Question: Was there a Loss??


Loss: Selling under FMV at the time of gift.
Gain: selling over donors Basis
Middle Ground: No Taxable Gain - No Deductible Loss = Selling between FMV and
donors basis.

If there is a Loss
To Compute Loss, the Donee must use as basis, the lesser of the donors basis OR the
fair market value of the asset at the time of the gift.

Ex: Donors basis in a gift is $ 100. FMV at the time of gift is $ 50.

44

Donee sells for $ 30 [Represents a loss when selling under the FMV when gifted]
B/c there is a loss, can use different basis calculation.
Basis = lesser of donors basis or FMV at the time of gift [Basis = $ 50]
Donee can report a $20 loss. (assuming 165) ($30 - $50 = - $20)

Donee Sells for $ 100


Basis = $ 100. No Gain, No Loss. Anything over $ 100 is taxable to donee.

Donee Sells for $ 80


Cannot deduct loss because the loss was on the donors watch. Cannot tax
gain because the donee has not had any gain until sold for over $ 100.

Anti-Loss shifting is a trap for the unwary


people won't realize that the basis goes down after the exchange, and the donee
won't be able to use the loss
Loss will disappear!!
Not a good idea to exchange an asset which declines in value! The decline won't
create a deduction!!

Gift to a spouse with a loss?


Anti-Loss shifting rule DOES NOT APPLY to 1041 transfers between spouses
one economic unit!

Part Sale - Part Gift


[WON'T have Anti-Loss Shiting AND Part Sale-Part Gift Didnt do in class]
Ex: Gans owns an asset: Basis $10, FMV: $100. Gives to Daughter for $50.
Income to Daughter? Daughters Basis in Asset?
Bargain Sale to Daughter = GIFT under 102. [so no gain to daughter]

IRS Reg:
Gans Basis?
Realized Gain = $40
Sold for $50 with Basis of $10.
Daughter Basis?
Basis in Asset = $50
Donee investment = $50
Gans original basis of $10 + $40 = $50 (also equal to what she
invested)

Academic Literature Model NOT THE LAW


Separate Transaction into components (apportion the gift and sale aspects)
Selling half and gifting half to Daughter

45

FMV = $100 & Price = $50 price represents of asset - Basis is split evenly
1/2 of the total $10 basis for each transaction = $5
Selling Half: Price = $50, Basis = $5
Gifting Half: Basis $5 carried over because it is attached to asset

Donor Gains:
Sale: AR ($50) - Basis ($5) = Realized Gain ($45)
DIFFERENCE FROM LAW: LAW puts full basis into sale aspect, and
nothing apportioned into gift aspect
Gift: No Gains from a gift

Daughters Basis: donee basis + donees investment = $55


Gift transaction: donee basis ($5)
Sale transaction: donees investment ($50)

Testamentary Gift Basis


1014 Basis Of Property Acquired from a Decedent

The basis of an asset acquired by testamentary gift is the fair market value of the asset at
the Donors death.

This creates Horizontal inequity:


Some people enjoy disappearing gain, and some people dont. Depends on
the FMV and Donors Basis.

Also creates Vertical inequity


Lower end people dont have a lot of assets with great appreciation value.
Enjoyed more by upper end people.

Death-Bed Gift Might be a Bad Idea


If you gift when still alive, basis will be calculated subject to 1015 (sticky note). If
just gift in a will, the basis may rise to the FMV and the donee can enjoy the
disappearing gain.

46

Ex. Asset FMV = 100 and basis = 10.


Gift Inter Vivos (1015): Donees basis = 10
Testamentary Gift (1014): Donees basis = 100 [disappeared gain! yay]

1014(e) (Closes a loophole)

The Old Loophole: Gift asset to dying friend and have them give it back in their will.
This can increase your basis to the FMV!

Rule: 1014(e): If the gift is made to the decedent within 1 year of death and then the
asset is bequeathed back to you or your spouse, you do not yet the 1014 basis
adjustment.
Note: Only to you or your spouse. The loophole doesnt count your children
or anyone else. However, service may argue step transaction doctrine and
substance over form. Taxpayer then argues that death was not a prearranged step.

International Trading - Employer giving asset to Employee


International Trading
Rule: When an employer gives an asset to an employee, we use the Sale/Purchase model
(1012) rather than the gift model (1015) for computing basis.

Ex: Employer has an asset worth 100 with a basis of 10. Employer decides to give the
asset to employee as a gift
First Tier of Analysis (Amount Realized)
Employee will have income (102[c] not a gift). The income is equal to FMV
so income = 100.
Employer can take a business deduction.

Second Tier of Analysis (Gain/Basis)


Employer is treated as having made a sale (using sale-purchase model).
Employer recognizes gain of 90. (basis 10, FMV was 100)
Employer deduction = 100. (no sympathy for recognizing the gain)
Employees basis will be 100 (already taxed on 100 so function 2 step up)

Need to get appraisal to know the value of the deduction (which triggers the gain). Still no
sympathy because the gain will never be higher than the deduction. (Gain will never be
higher than the value of the asset by definition).

International Trading DOES NOT APPLY IF talking about spouses.


1041 will apply and husband/employer will have no gain.
Reason: Mostly filing joint returns so it will wash out at the end of the day.

Ex: Husband is the employer and Wife is the Employee. Husband gives
wife/employee an asset. 1041 applies, not International Trading.
Recap: 1041 = spousal transfers are treated as a gift (gift model 1015)

Depreciation Deductions
167 and 168: Depreciation Deduction
In order to take a depreciation deduction, the asset must be used in trade or business, or to
produce income.
Some things are never subject to depreciation deductions
Land is not subject to depreciation deduction. (Doesnt get used up).
However, the cost of improvements can (Ex. build factory on land).

47

Straight Line Depreciation: It will decline equally in value each year.


LOOK FOR ON TEST: Question will say what LIFE to use (X-number of years)

Ex: $5,000 machine with a life of 5 years. It produces 1,200 of income per year.
In effect: Investing 5000 to make 6000. (1,200 x 5 years - 6k)
Assume it will depreciate on a straight line basis (1k per year for 5 years)
In year 1: 1,200 of income, 1,000 depreciation deduction. (200 income).
200 per year for 5 years = 1000 (same in effect).

168: The Code permits accelerated depreciation


Realistically the machine probably doesnt depreciate 1k each year. Maybe 300 the
first year, 800 the second year, etc... The code is generous and allows accelerated
depreciation deductions.
Taxpayers like the deductions soon rather that later--- save tax immediately.

1016: Adjustment to Basis


Basis is reduced by the amount of depreciation deductions.
Required to have a Basis in an asset to get depreciation deduction on the asset!

Tufts and Crane


Question: People borrow money to buy Assets: what is the impact in terms of amount
realized and basis? [basis and basis reductions from taking depreciation deductions]
Regulation 1001-2: Codifies rules from Crane and Tufts.

Borrowing:
If I lend someone $100, that person doesnt have income because there is no real economic
benefit.
Have $100 cash but $100 liability to repay
Buying an asset without the cash:
Seller Financed: Buy an asset from seller and pay the seller an amount in
installments over a number of years
Borrow Cash: Buy an asset from the seller and he gets a lump sum, I repay the
lender
lender might want mortgage on the asset, so he can get the asset if you dont
pay
Someone Buys Asset with Mortgage on it
Selling an asset with a mortgage on it - TRIGGERS DEBT - Buyer cannot take over mortgage
When someone takes over your mortgage:
You see Economic Benefit!!
Buyer is taking over your liability!
If your debt is assumed by purchaser, it enters into Amount Realized, as if you
received valuable consideration [Crane]
Disposing Debt - included in Amount Realized

48

Getting Loan - What is Basis?


When you get a loan, treated as if you invested capital because of the likelihood of
repayment - grants you a basis in the new assets!
Crane & Reg 1001-2: Treat Liability as if you were going to repay
Debt incurred in acquiring Asset - included in basis

Now that you have a basis you can take depreciation deductions against that basis!!

Ex. Buying an asset with borrowed money for $100. Note says you will promise to repay $100.
Asset has 5 year life, and you want to take depreciation deduction in year 1.
Even though you didnt invest capital yet - treated as if you did because of promise to repay
the $100 loan
Because of high likelihood of repayment - Can now include the loaned money into
basis calculation
Basis = $100
Now that you have a Basis, can take depreciation deduction which in turn lowers that basis!
$100 FMV and 5 year life = $20 / year depreciation deduction over the 5 years
Basis will be reduced by $20 - giving you $20 depreciation deduction / yr
Example: Calculating Gain [Basis = loan b/c high likelihood of repayment]
Someone agrees to buy my building for $120. I got $100 note from bank when I bought it
originally. Building is encumbered by a mortgage!
$120 (AR) - $100 (b) = $20 (Gain)
Pay Back $100 to bank and see $20 Gain!
Made $20 Gain without ever actually investing any money!! [Concept of Leverage]
NOW: I took depreciation deduction in 1st year. SOLD building in 2nd year.
B: $100 - $20 (depreciation deduction) = $80
$120 (AR) - $80 (B) = $40 (Gain)
$20 of Gain is from sale
$20 of Gain is from depreciation recapture (took false depreciation since
asset didnt lose value - need to pay this back!)
NOW: Took depreciation still, SOLD for $80.
$80 (AR) - $80 (B) = $0 (Gain)
Asset DID lose value - depreciation!
I saw $20 loss of investment.
Recourse v. Non-Recourse Note
Recourse Debt: (Personal Liability) - If you dont pay back the loan, lender can sue you
personally
Non-Recourse Debt: (Involves a mortgage) - If you dont pay back the loan, only recourse is
against the asset, not against the person

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Non-Recourse Note:
3 Ways Non-Recourse Debt can originate:
1 Purchase asset and provide in note it will be without recourse against me
a Bank will likely charge extra interest in exchange for the higher risk
2 Own an asset encumbered by a mortgage; Purchaser comes and agrees to take over
the mortgage; and purchaser agrees to assume the mortgage.
a Assume: purchaser agrees to pay and will be personally liable for failure to pay
b Subject to the mortgage: purchaser taking on mortgage that is non-recourse,
purchaser is not personally liable to repay
i So if dont pay: purchaser will lose the property but the bank can still
come to original person, not the purchaser
3 Original Person had Recourse Debt but died. Person who inherits an asset through a
will is not personally liable on the mortgage, the debt becomes non-recourse.

Crane
Basis for income tax purposes with Non-Recourse Debt: [Crane]
Non-Recourse Debt treated the same as Recourse Debt and included in basis!!
Assumed you will repay the mortgage - so treated as if you paid in cash from your
pocket = capital investment
Ex. Calculating Basis on Inherited Asset with Mortgage. FMV = $10; Mortgage = $10K
1014: basis when you inherit an asset is the FMV
Property Subject to Mortgage = $10k
FMV = $10k with Mortgage = $10k NO Equity
Assumed she will repay the mortgage
Treat Recourse and Non-Recourse the same
Basis = FMV!! [$10k]
If basis started at $0, each repayment of mortgage would provide an upward basis
adjustment (investment of capital), creating a very messy situation
Abuse of Crane:
Negative Equity: Value of the asset is way less than the amount of the debt

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Can only include non-recourse debt into basis if there is a likelihood of repayment
Likelihood of Repayment: Where the value of the asset is at least equal to the debt
[like Crane] or greater than the debt
If the value of the asset was less than the debt (negative equity), NO likelihood of
repayment, CANNOT include non-recourse debt into basis

Tufts
Any Debt You get Rid of is Included In Amount Realized (even non-recourse debt) [Tufts]

Ex: Taxpayer purchased property with non-recourse debt of 1,800,000.


Basis = 1,800,000. Property value declines to 1,400,000.
New basis = 1,400,000 (he took depreciation deductions)
Taxpayer finds a buyer to take property subject to the mortgage
IRS says he had a gain of $400,000. (because his amount realized was
1,800,000 when the purchaser took over his mortgage and his basis was
only 1,400,000)
Taxpayer tried to argue negative equity from Crane by saying that he had
no likelihood of repayment so non-recourse debt is not included in basis.

Tufts Rule: Any debt you get rid of, even non-recourse, is included in
amount realized. (IRS wins, he had a gain of 400,000).

Dont care about the Crane likelihood of repayment test at the time of the sale.
Only at the time of purchase to determine basis (for false depreciation deductions).

Capital Gains

Character of the gain is important: capital gain or ordinary gain?


Capital Gain gets put into a separate basket for taxing

Reasons for Capital Gains Lower Tax Rate:


Compensate for IRS failure to adjust for inflation
Most of the gain over the long term of an investment is merely inflation
which gets included in amount realized and taxed
Prevent Lock-In
Taxpayer has the trigger in his hand (deciding when to sell) which will
cause the tax liability - resulting in taxation of the gains
If you will get taxed at top marginal bracket (35%) might not sell the asset!!

Capital Gain: Subject to maximum of 20% tax rate


Long Term Capital Asset: Capital Gain max of 20% rate of tax
Long Term: Longer than 1 year (1 year and a day)
1221 Capital Asset: Negative Rule - (Broad Definition) Almost all assets are capital
assets, except for what is listed in the code

Ex. Own a home for 1 year and a day


Get $250k ($500 if married) exception on the income from sale

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Anything over that exception taxed at 20%! Capital Gain

Ex. Sell Stock - Basis: $10k; FMV: $20k


If you own it less than a year and a day = Ordinary Income Tax Rate
$20k - $10K = $10 K Income @ Marginal Tax Bracket Rate
If you sell it after a year and a day = Capital Gain and 20% tax rate
$20k - $10k = $10k @ Capital Gains 20% Tax Rate
Exceptions to Capital Gain:
Inventory: people who buy and sell inventory do not have capital gains
Ex. Department Stores, Electronic Stores, etc.
Holding onto the inventory is not long term investment
They bought the inventory for the purpose of selling it
NO worry of lock-in preventing the sale of the items
Whole point is to sell your inventory
Real Estate as inventory:
Taxpayer owns multiple lots and builds houses to sells in pieces, are the lots
inventory????

1245 and 1250: Depreciation Recaptured


If you took depreciation deductions on a false premise (asset didnt actually
depreciate and you sold it for a gain), the gain is recaptured as ordinary gain
Depreciation repayment (make amends gain) is taxed at the same rate
which you were at when you took the deduction
Want to retain integrity of make amends concept

Ex. Bought asset for $10k. Took depreciation deduction of $10k, and basis is now $0. If you sell for
$10k, NO loss in value. [$10k(AR) - $0(Basis) = $10k(Real. Gain)]
Took depreciation deductions on false premise! The asset did not lose value!
When you sell: need to make amends gain
Taxpayer took the depreciation deductions at 35% Rate.
Does taxpayer make amends gain use gain capital rate (@ 20%) or ordinary gain marginal
bracket rate?
$10k deduction at marginal bracket of 35% worth $3,500 savings.
$10k deduction at capital gains rate of 20% worth $2,000 savings.
Using 20% Capital Gains rate wouldnt fully make amends
Deduction was used at Ordinary Gain rate - Recaptures Deduction should be at the same
rate!!

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NOTE: If he sold for $12k. Realized Gain = $12k.


Maybe:
$10k of the gain is Depreciation Recapture @ 35%.
$2k of the gain is Capital Investment Gain @ 20%