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Tax Outline (Mike Lees Outline is Better)

I. Introduction to Taxation
a. Overview and History
i. Revenue Sources for Federal Government
1. 49% - Individual income tax
2. 10% - Corporate Income Tax
3. 37% - Social Security/Medicare tax
4. 3% - excise taxes
5. 1% - Estate, Gift, etc.
ii. State tax difference is that 19% of state tax revenue is from Sales Tax

b. The Rate Structure

i. Social Security
1. First 89K, 6.2% from you and 6.2% from employer
a. If self employed pay 12.4%
2. Base is adjusted for inflation
3. So if you only make employer pay, wages will go down
ii. Medicare
1. 1.45% on all wages. Employer pay 1.45% too
2. If self employed pay 2.9%
iii. Income Tax
1. Gross Income - 61
a. All income from whatever source derived
c. Its structured so everything is taxed, but later in the code it says
that some of this is not taxed
2. Capital Gains Gain from sale of property that is not inventory
a. Inventory property that is sold as part of ordinary business
b. Usually taxed at lower rate than income
c. Only pay once gains are realized
3. Adjusted Gross Income (AGI) 62
a. Gross Income minus the following deductions
b. This is a key number in a lot of tax provisions
4. Taxable Income - 63
a. AGI Deductions Exemptions
b. So if you dont itemize its
i. AGI Standard Deduction Exemptions
5. What you pay in taxes
a. Taxable Income Tax Credits
b. Most important credit is child tax credit
iv. Alternative Minimum Tax (AMT)
1. Denies you some deductions and taxes at lower rate
2. Its was used to prevent people from paying no taxes by using tax
3. Hitting a lot ore people now because
a. Bush Tax cuts lowered taxes generally, but not the AMT
b. AMT is not fully adjusted for inflation
4. Does not include deductions for
a. State and local taxes
b. Exemptions for kids
c. So it hits people who
i. Live in high taxing states
ii. And have a lot of kids
c. Rate Structure Part II
i. Marginal Rate
1. Its what a taxpayer would pay on for an extra dollar of income
ii. Average Rate
1. Total amount she paid in taxes/tax base
iii. Example
1. Strucure is: 10% on first $10K; 20% on $10K-$40K; 30% on over $40K.
2. If Mary makes 25K shell pay
a. 10% of 10K + 20% of 15K
b. Total = 1,000 + 3,000 = 4000
c. Marginal Tax rate is 20%; Average Tax Rate is 16%
iv. Policy Considerations
1. If we care about incentive to work, we should care about the
a. Because if she works an extra hour, thats the rate shell be taxed
2. If we care about total tax burden, we should care about AVERAGE Rate
3. Tax credits dont affect marginal rate so no incentive to work
a. But they are a fairness issue people with kids need more money
v. Actual Structure
1. Not over $7150 10%
2. 7150-29,050 $715 + 15% above 7150
3. 29050 70350 - $4,000 + 25% above 29,050
4. etc.
5. Double for Married
6. Different structure for head of household (singles w/ children) and
married filing separately (worst Schedule)

d. Tax Policy Goals

i. Efficiency
1. Minimize undesirable tax-induced changes in behavior
2. Dont want tax system to discourage people from working
ii. Encourage desirable behavior through tax incentives
1. Deduction for charitable giving
2. Incentive to invest in business encourage businesses to make pollution
free cars
iii. Discourage undesirable behavior
1. Sin taxes cigarette smoking
iv. Minimize administrative costs
1. High administrative costs are bad for both government and taxpayers
2. In 1986, closed loopholes and lowered rates so it was simpler to fill out
the tax return
v. Private Enterprise versus Government
1. For Private Enterprise
a. Firms that produce poor or overpriced goods will be driven out of
the market
2. Against Private Enterprise
a. Will try to increase profits by cheating consumers, selling bad
i. Ex: Sears Auto Repair set up inventive structure to screw
3. For Government
a. Some Goods and services cannot be effectively produced by the
private sector
i. National defense, police, parks, highways
4. Against Government
a. Without competition or need to make a profit, government
workers may lack incentives for hard work and innovation
5. Conclusion
a. Private markets work best when:
i. Wan to have a lot of competition
ii. If people can properly evaluate goods and cervices
b. If these dont exist
i. Have government run it
ii. Or Heavy regulation
c. Clothing good for free market; insurance bad
vi. Fairness
1. Apportion the tax burden fairly between taxpayers with different
incomes and needs
a. Utilitarian redistribute to maximize utility, but would balance it
with not having rates so high they wouldnt discourage becoming
b. Right-based
i. Conservative: You have right to keep what you earn
1. Low tax rates and only essential government
ii. Liberal: Everybody ahs right to education, healthcare,
good standard of living
1. Tax system should guarantee these rights
2. Tax Ethics
a. Horizontal Equity Similarly situated should pay the same tax
b. Vertical Equity Taxation according to ability to pay
e. Bush Tax Cuts and Distributional Effects
i. Made new bracket from 0-7000 went from 15% to 10%
1. Every taxpayer paid $350 less in taxes
ii. 7000-27050 got no changes in marginal rate, stayed at 15%
iii. All but highest after this went down 3%. Highest went down 4.6%
iv. Limitation on itemized deductions and personal exemptions for highest bracket
will be phased out over 5 years beginning in 2006
v. Child tax credit increased from $500 to $1000
1. Helped the poor
vi. Standard deduction for married went to twice the amount for singles, rather than
1. Probably helped poor families
vii. Tax rates on dividends and capital gains were reduced
1. Helps rich
viii. Estate tax exemption increased and estate tax rates lowered
1. Helps rich
ix. Distributional Effects
1. Figures
a. Top 1% married is $300K; single is $200K
b. Average income for family of 4 - $55K
2. Who gets the tax cut
a. Top 20% gets 73.1% of the tax cut
b. Top 1% gets 30% of tax cut
c. This is distorted because tiny cut gives them a lot of money
d. Two true things
i. Huge percentage went to rich
ii. They also got a disproportional amount of it, percentage
3. The right measure to look at is Change in After-Tax Income
x. Financing
1. Two alternatives
a. Equal Dollar Financing
i. Each person/family will lose an equal dollar amount of
government benefits or will pay an equal dollar amount in
a future tax increase
b. Proportional financing
i. Each person/family will lose an amount of government
benefits or pay future additional taxes in proportion to
their current income
ii. If you think its going to be paid for by tax increases in
the future propoertional finance is best way to present
xi. Argument for supporting tax cuts
1. Rich get most of the benefit as they should, theyve paid too much in

f. Normative Theories of Fair Income Redistribution

i. Benefits received Theories
ii. Rights base theories - Conservative
1. Wilt Chamberlin Theory In a society with equal wealth, hes willing to
play an extra day
a. Griffith criticizes this
b. Cant structure this in society, can only have a marginal rate
system where it would be so Wilt would play this game tax free
c. When tax system prevents Wilt from working, charging him
higher tax that he would choose not to play, makes everyone
worse off
d. Higher marginal tax rates can discourage work efforts is accepted
by everyone
iii. Rights Based Liberal
1. Everyone has right to healthcare
iv. Utilitarian theories
1. For redistribution: Declining marginal utility of income
2. Against redistribution: Efficiency costs
v. John Rawls: A theory of Justice
1. Veil of ignorance argument
a. If you dont know what you would pay, its what you would pick
b. Says people would insure they have liberties secured right to
vote, free speech; and then theyll worry about distributional
2. Leximin: accept inequality only if it improves the welfare of the least
well off
a. This Rawls view of what happened in veil of ignorance
b. Widely criticized by Economists because its not how people act
i. Because people will take a gamble, and if the middle and
upper are a lot more in one but lower is lower, then they
may pick that world

g. Lottery aside
i. It has a payout of 53%
ii. Poor people spend 4 to 5 times as much as a percentage of income as rich on
1. Economists say that poor sees it as money making opportunity; rich sees
it as entertainment
iii. Used for college scholarships
1. But goes to wealthy students a lot more than poor students
iv. States with lottery havent increased money on education, it just allowed money
to go elsewhere and let lottery pay for education

h. Compliance and Administration

i. Self-Assessment system
1. Limited assistance from IRS
a. Help lines
b. Free publications
c. Will do certain calculations for you
ii. Pre-Payment
1. Withholding curbs motivation to cheat because dont have to pay a lot,
only get a smaller refund
2. Quarterly returns independent contractors do this
iii. Penalties
1. Civil
a. Negligence, fraud, substantial underpayment
b. Interest due on underpayments
c. IRS usually goes after outrageous cases only
2. Criminal
a. Serious intentional fraud
3. Likelihood of Apprehension
a. High for income subject to information returns (W2s, 1040s)
b. Low for most other forms of evasion
i. Low audit rate
ii. Hard to disprove taxpayer claims
1. Easy to fabricate records charitable donations,
not great records
4. How to get caught cheating on your taxes
a. Fail to report income on 1099
iv. Why its a good system
1. Excellent information system
2. Efficient Tax System
3. Americans as ethical matter, feel greater moral obligation to pay taxes
they owe then other citizens countries
v. Audit
1. If you dont respond to audit letter then you lose a lot of procedural
a. IRS can just take the money from you if you dont respond
b. Response is either pay or file an objection
2. Often disputes can be settled by negotiation and compromise
3. If no agreement the IRS can order payment and taxpayer has 3 choices
a. Decline to pay tax and file petition for review in Tax Court
b. Pay tax and sue for a refund in Federal District Court
c. Pay tax and sue for a refund in US Court of Federal Claims
i. Some Tax Terms and Concepts
i. Realized
1. When the gain is obtained
ii. Recognize
1. Show the gain or loss and pay or reduce taxes of it
iii. Example
1. Sell painting worth $5K; bought it for $1K
a. Realized $4K gain during sale
b. Recognized the gain when pay tax on it
iv. Deductions versus Credits
1. Deductions lower your taxable INCOME
2. Credits lower what your actual tax bill is
3. So Credits are a lot more valuable than deductions
j. Entities
k. Deferral
l. Sources of Tax Law
i. Internal Revenue Code of 1986
ii. Judicial Decisions
1. District Court
2. Tax Court
3. IRS may acquiesce or may continue to challenge the decision
iii. Treasury Regulations
1. Treasury interpretations and/or delegated legislative enactments
2. Notation is 1.code section
a. So for IRC 132; its Regs. 1.132
iv. Committee Reports
1. Explains legislative history and gives legislative interpretation of the law
2. Collected in The Bluebook
v. Revenue Rulings (Rev. Rul.)
1. Treasury opinions on matters of law arising in particular factual settings
2. Court gives no weight to them
3. But is guide how to avoid fights with IRS
vi. Revenue Procedures (Rev. Proc.)
1. Treasury opinions regarding rights and duties of taxpayers or other
2. Deals with procedural matters what taxpayers have to do to comply
with tax law
vii. Private Letter Rulings (LTR)
1. Responses to taxpayers inquiries regarding specific factual situations
2. Rulings are valid for requesting taxpayer only and may not be cited for
other cases
3. In big mergers, lawyers can ask IRS for Private Letter Ruling
4. Describe transaction to IRS in letter and then IRS will issue a letter that
repeats relevant info you tell them
a. And if thats followed, that is ther result
5. The LTR supercedes laws if its followed
6. Never precedent
7. Only reason NOT to do one is if you are doing a sleazy transaction and
dont want to tip off the IRS about it
viii. Griffith says the best sources for law are the Tax Management Portfolios
1. They are done by code sections

II. Poor People Readings

a. The Marriage Cure
i. Kim Henderson 22, single, no children, telemarketer
1. She was a telemarketer because she could get to it and she was able to do
2. She didnt like it because she felt sleazy selling security systems to
people who really didnt need them
3. She couldnt get a job at the mall because she couldnt get there and she
didnt have a working phone so she could get calls from potential
ii. Things she couldve done differently
1. Give employers Correens number
2. Not quit the telemarketer job before having a new one
iii. Bottom Line
1. When poor people have bad luck and make stupid decisions the
consequences seem to be a lot worse
iv. Two things to be true
1. You can see A,B,C of things that they shouldve done differently that
would lead to better circumstances
2. Rich and poor do D,E,F and it affects the poor a lot more than rich
b. Inferred from readings, how do you help the poor?
i. College Help
1. Financial
a. Cost of books and fees can be very expensive
b. Pell Grants are good because $2000 to poor can go a long way at
Community College
2. Guidance on how to apply and when you need to do this big problem
ii. Improvement of Employment Services
1. Phone calls
2. Provide with Information and Job Skill Techniques
iii. Public Transportation
1. Improve it to allow people to get there
2. Ride Share program would help
iv. Subsidized Phone Service
v. Encourage Scatter housing federally financed scattered throughout town
vi. Health Care help
vii. Why arent these done?
1. It would involve raising taxes
2. These arent politically popular things to do
c. Not Poor Enough
i. Cassie Stromer Medicare Case
1. Age 76 with Neutropathy and Depression
2. Income is $9,654/year from Social Security (686/month) and Pension
from her former employer Newspaper (119/month)
3. Official Poverty line is $9,310/year
4. Her fixed monthly expenses are
a. Rent - $72 its a HUD Subsidy but may lose it because shes
above the poverty line
b. Electricity - $66
c. Phone $50
d. Cable TV $45
e. Prescription Drugs $328
5. What she can really use is better health insurance for cheaper drugs
d. Bushs Problems with health insurance
i. Lawyers sue too much
ii. People use it too much overuse of doctors
1. People will go to the doctor for things they wouldnt go to if they had to
2. And will take prescription drugs if they are free when over the counter is
cheaper to the market but not free
a. Should make prescription drugs cheap enough to not be too bad
but not cheap enough to make it economically inefficient.
e. For Richer Paul Krugman
i. Wealth has become more unequal over last few decades
ii. Salary Growth
1. Average salary rose about 10% between 1970 and 1999
2. Top 100 CEOs rose from $1.3M to 37.5M in same period
3. 1970 CEOs paid 39X average worker
4. 1999 CEOs paid more than 1000X average worker
5. Most of the inequality is in the top tiny percentage
iii. Census Data
1. 1979 to 1997 after-tax incomes of top 1% rose 157%
2. During same period gain for middle income was 10%
iv. Inequality
1. Top 1% gets 14% after tax income, about the same as bottom 40%
v. Reasons for growing inequality Three Theories
1. Globalization
a. In 1950ss, almost all of the cars in US were made in US
i. The jobs of steel worker was great back then
ii. Average salary of blue collar worker were very close to
white collars back then
b. Now these blue collar workers jobs are going oversees so theres
a huge wage gap
2. Increase of relative demand for skilled workers
a. Bigger demand for higher education in computer age
3. Superstar Phenomenon
a. Comedian Example in 1915 a lot of good performers making a
nice living in Catskills
i. Now theres only a few superstars making a shit load of
money in TV
vi. Krugman hypothesis
1. Back then, CEOs wouldnt ask for so much money
2. Now each one asks for above average pay so it keeps creeping up
3. Also CEOs are the ones who pick the people who choose salaries
4. Different than entertainment contracts, those stick to market value
5. CEOs still get big raises even if there was a bad year
6. There is now Greed Unbridled
vii. Are Americans Better Off?
1. The Swedish Comparison
a. Swedish GDP is similar to Mississippi but
i. Higher life expectancy
ii. Half the infant mortality
iii. Longer vacations
b. Still real productivity per person is 16% lower than US but
i. Median Swedes have standard of living similar to median
ii. Bottom 10% of Swedes much better off than bottom 10%
of Americans
2. Bottom Line
a. Swedes at Top doing worse than Americans
b. Swedes in Middle doing same
c. Swedes in Bottom doing better than Americans
III. What is Income?
a. Basic Concepts
b. Noncash Benefits
i. Efficiency
1. If youre allowed to tax-free pay in something other than cash, then it
can be inefficient because it changes behavior
ii. You are taxed on anything for fair market value received in exchange for labor,
barring a provision in the code to the contrary. Including:
1. Employer paid rent
2. Employer paid payment to insurance company if in employees name
a. This sucks, because employee doesnt have any money in this
situation in which to pay the tax.
3. Employer gift to employee not really gift
iii. Bengalia Case
1. Hes manager of Royal Hawaiian Hotel and under contract hes required
to live there
2. Court Holds NOT TAXED
3. The room and board are conditions of his employment
a. Its required for his job and not considered compensation
iv. Alternatives to not taxing and why they wont work
1. Tax on Retail Price
a. He doesnt value it as much as Fair Market
b. He would demand higher wage to compensate for additional tax
c. Resulting in one of two things
i. He wouldnt get the money and theyd have to hire
someone more incompetent
ii. They would pay him more and would have to charge
higher rates to customers
1. Then the economic implications of higher hotel
rates would be bad because less airline travel, etc.
2. But the taxes would just SHIFT spending to
something else, like the people will by electronics
instead of going to hotels
d. Govenremtn should be neutral and not distort choices
i. In this case, shouldnt tax retail because theres a good
business reason for him to live in hotel, and retail price
would distort his behavior
2. If they didnt give him the free room and board and rented the room out
to customer and gave him $5000 more in salary?
a. Both would be willing to do that
b. BUT theres a good business reason to have him live there, hence
theres an inefficiency if its not done because tax policy distorted
3. No tax at all in all cases?
a. Even if its not useful for managers to live at hotel, they would
still live there because itd be worth it
b. Motivation to pay in room and board even if not needed
4. Taxing the subjective value to Bengalia?
a. Very difficult to find out what his subjective value will be
b. If we did it would be a perfect result
c. An alternative way to measure this may be the cost of alternate
arrangements or cost to hotel
5. Basic Principle: We do not want taxation to shift behavior
v. Food and lodging provided by employer - 119 (After Bangalia)
1. Meals have to be furnished by or on behalf of employer for convenience
of employer
2. Generally, if they bring food in, then its probably not taxable because
its furnished on the business premises
a. But a 1st floor cafeteria wouldnt work because its not on
business premises
3. Police Officer Example
a. To make tax free would need to
i. Require officers to eat at those restaurants where police
department contracted in the district
1. Its provided by employer
2. On business premises the district hes patrolling
3. Convenience of employer because want police
ready to work at all times
ii. If on a stakeout its always tax free
1. Its a business necessity
4. Employer must have a good business reason for providing the food
rather than a compensatory reason.
a. Good reasons include
i. Need for employees for emergencies
ii. Short lunch period required
b. Examples: Military feeds provided by army, need them on duty
all times premises is Iraq
5. Basic Principle: Theyre doing it because its helpful to keep them
around, and its not just compensation
6. Need these strict rules to stop abuse
a. If no rules would have fire departments having programs that
would have their off duty people come in and get free lunch
7. If theres a choice between a tax-free benefit and money, then youll be
taxed on whichever one you take
a. Choices undermine the tax-free treatment of the food
b. Thats why tax free life insurance at work cannot be traded in for
8. Restaurant exception
a. If you work for restaurant they can provide you with a free meal
b. There doesnt have to be a good business reason why
vi. Lodging Provided by an employer - 119
1. Must be a condition of employment; typically you must be on duty at all
2. Must be on premises of employer
3. Need to have good business reason as to why he has to live there
4. The fact that the contract requires him to live there doesnt necessarily
make it OK under this condition

c. The Efficiency Cost of Taxation

i. DEADWEIGHT LOSS In general, it occurs when a tax causes an individual to
change her behavior
ii. Taxes are inefficient when two things happen
1. It causes people to change their behavior to be worse off
a. i.e. wouldve rather had the taxed thing than the non-taxed thing,
but the tax made her get the non-taxed thing
2. Government makes no gain from tax because people avoid the taxed
a. If people by the non-taxed thing, government gets no money
iii. SUBSTITUTION EFFECT Higher tax rate will make you work less because
youd rather do something else then make your taxed salary
1. Look at these for efficiency concerns changed behavior
iv. INCOME EFFECT Because youre making less, youll work harder to try and
make more money
v. Taxes changing behavior
1. Young Single Men and Women it doesnt hardly at all
2. Young Married Women it has a 3-5X greater impact then men
a. With kids its not worth them to work because of daycare, etch.
3. Older workers It changes behavior a lot
d. Corporate Taxes
i. Individual Proprietorship
1. Pay the regular income tax
ii. Partnership
1. Partners pay taxes, partnership does not
3. S Corporation and LLCs are taxed like this
iii. C Corporations
1. Pay separate corporate tax
2. Distribute profits as dividends
a. Theyre taxed at lower rate than income
3. Lower rate on dividends allows for efficiency
a. If corporate tax + dividend tax = income tax then there will be no
change in behavior between choosing to be a corporation or
4. A lowering of dividend tax would create a one-time windfall benefiting
current shareholders
a. It doesnt promote efficiency because it would just be on old
capital, the behavior that they didnt want to change already
happened, so you dont really need it
b. Dividend relief will make the current price go higher, to account
for it so old capital wins and new capital is not affected
e. Efficient Taxation that Changes Behavior
i. Two reasons
1. The behavior is undesirable because it produced a negative externality
2. More controversially, the behavior is undesirable because the individual
will not act in her own best interest without the tax
a. Paternalism
ii. Example Smoking
1. Smoking produces a negative externality in the from of second-hand
2. Smoking may not be in the enlightened self-interest of the smoker
iii. A tax is the amount that reflects the harm of the negative externality will lead to
1. True Cost = Cost of cigarettes + negative externality that other people
are willing to pay to not have this around
f. Qualified Pension Plans
i. Tax Treatment
1. Employer can deduct contributions at time of contribution
a. As a business expense
2. Employee is not taxed on amounts contributed by employer until those
amounts are withdrawn
3. Employee is not taxed on interest or other gains on amounts invested in
the pension plan until withdrawal
4. Amounts withdrawn from the pension plan are taxed to the employee as
ordinary income at time of withdrawal
ii. Government loses ability to tax employer & employee
iii. Will not be taxed as interest accrues only taxed when withdrawn
iv. Types of Plans
1. Defined Benefit Promises specified benefits, typically in the form of a
retirement pension based on levels of compensation and years of service
a. Ex: Public school teachers get 2% their average best 5 year salary
for each year worked (up to 35 years)
b. Good about them
i. You know ho much your going to get at retirement
ii. Very secure
c. Bad about them
i. They can be over or under funded
ii. Over: when stock market does very well then the pension
funds will have too much money
iii. Under: Company can go belly up
d. Tax Consequences No tax when goes in, but taxed when comes
2. Defined Contribution The employer promises a specific contribution
for each employee
a. Contributions typically are invested in stocks, bonds, mutual
b. Retirement benefits depend on return of those investments
g. Social Security
i. Funding Social Security: 12.4% of wages up to $90,000
ii. Where it goes today: about 75% pays current beneficiaries; the rest purchases
government bonds which are held in trust for payments in the future
1. (Also, borrowing for social security doesnt count in the federal deficit,
so really weve borrowed more money then the deficit says)
iii. Ice berg looming in future if nothing done
1. 2018 Payroll taxes will not cover payments to current beneficiaries
(But such taxes plus the interest on the government bonds held by the
trust fund will.)
2. Several years after 2018 Taxes plus interest on bond wont cover
payments to current beneficiaries, so SS trust fund will need to sell some
of the bonds to cover payments.
3. 2042 Payroll taxes will not cover payments and SS trust fund will have
already sold at it bonds. Thus SS will not be able to cover promised

iv. Will social Security be bankrupt in 2042 if nothing is done?

1. No, however, it will be able to cover only about 70% of promised
v. Right now theres 1.6Trillion in the Social Security Fund

vi. The 10.4Trillion shortfall that Bush says is done by calculating the Present Value
of expected shortfall FOREVER.
1. For example if the expected shortfall is 100Billion a year, its the Present
Value of that forever.
vii. Private Accounts
1. Theyd be pretty much the same as 401(k)s
2. Bushs proposal is that they can put 20% of what you put into social
security into a private account.
3. Example
a. No private: $4000 into SS
b. W/Private: $3200 into SS; $800 into account
c. So the SS Trust will have less in now
4. So government would need to borrow about $1T-$2T to pay off current
5. But later there will be less guaranteed benefits because of the private
accounts, so it will get more even out in the end.

6. If we have private accounts it would immediately reduce SS revenue

a. But it will reduce future obligations
7. Private Accounts dont solve the social security problem, but they still
may be a good idea
8. Social Security is a Defined Benefit plan
a. Under private accounts there will be a defined contribution plan
9. Also, now, rich dont get 2X as much as poor
10. But if there are private accounts the rich will get what they put in and
they will get what they take out.
viii. Saving the Shortfall
1. Increasing revenue
a. Raise the payroll tax rate
i. If we raise to 14.4% the problem will be solved
b. Raise the payroll tax base
i. Now, its up to $90K, which is about 85% of wages being
taxed. So if theres a modest increase over $90K over
ii. But removing the cap for good, it would be a HUGE
1. i.e. if you make $290K a year, your marginal tax
rate would go from 45% to 57% - huge increase.
About $13K more
c. Fund with general revenues
2. Decreasing benefits
a. Change from wage base escalator to inflation escalator
i. If goal was to have SS recipients buying power stay the
same then we would use an inflation escalator
ii. But now, we use wage base escalator which measures the
increase of wages.
1. Which is a higher increase than inflation
iii. The question is, Is social security supposed to keep
everyone out of relative poverty, or to keep people at the
normal level where they were when they were working
iv. If you go inflation, people will be less well off then the
normal of society then they were when they were
working. Because wages are growing faster then their
wage of social security, so theyd be relatively less
better off.
b. Raise retirement age and/or reduce benefits more sharply for
early retirement
c. Phase out benefits for the wealthy elderly
i. This would just turn it into a welfare system, Griffith
doesnt think its a good idea
d. Tax benefits at 100% of normal rates (rather than 85%)
ix. Bushs position
1. Flexible, but President Bush rejects either raising social security tax rate
or reducing benefits for individuals who are now age 55 or older.
x. Two arguments against Private Accounts
1. Government shouldnt put burden of loss on people
2. Government could invest trust in stock market, and private accounts
arent necessary for that.

h. Non taxable fringe benefits under 132

i. Gross income shall not include any fringe benefit which qualifies as a:
1. no-additional-cost service
2. qualified employee discount
3. working condition fringe
4. de minimis fringe
5. qualified transportation fringe, or
6. qualified moving expense reimbursement
ii. No additional cost service - 132(b)
1. Any service provided by an employer to an employee if
a. The service is offered for sale to customers in ordinary course of
business of the employer in which the employee works
b. Employer incurs no substantial additional cost or foregone
2. Nondiscrimination rules must be followed
a. Must be provided to all employees and not just managers
b. Can discriminate against highly compensated employees
3. Employee includes current, retired, or disabled employee, widow, spouse
and dependent child of employee
4. Reciprocal Agreements Any service provided by an employer to an
employee of another employer shall be tax-free if
a. It is under a reciprocal agreement and all the employees are in the
same line as the service they use
b. Neither employer incurs a substantial additional cost
c. i.e. Airlines can have a written agreement to allow other airlines
employees to use their flights
5. Ex: You work for bowling alley
a. Can get free bowling
b. Cant get free skeet shooting thats owned by bowling alley
c. Can probably get free pool thats in the bowling alley
6. If theres substantial cost like the skeet shooting example
a. If you tell employees to provide their own clay pigeons and
ammo and whatever else is expensive, then it would probably be
considered tax free
7. Policy Rationales
a. We want to encourage employers to offer these benefits
i. If theyre not offered, then therell be economic waste
empty plane seats, unused bowling lanes
b. Tradition and administrability
i. Its been a long tradition for firms to offer these benefits
ii. You cant really report the time you play pool at work
1. You would only penalize super honest taxpayers if
this is taxed
iii. Qualified Employee Discount - 132(c)
1. Any employee discount with respect to qualified property or services to
the extent such discount does not exceed
a. Property: Gross Profit of the price being offered to customers
i. Gross Profit % = (Agg. Sales price Agg. Cost of Goods
Sold)/Agg. Sales Price
b. Services: 20% max

iv. Working Condition fringe benefits - 132(d)

1. Any property or services provided to an employe of the employer to the
extent that, if the employee paid for such property or sevices, such
payment would be allowable as a deduction under 162 (trade or
business expenses) or 167 (depreciation).
2. Nondiscrimination rules DO NOT apply
3. Employer buying vs. Reimbursement
a. Both not taxable
b. But reimbursement is subject to 2% AGI floor ?????????
v. De Minimis Fringe - 132 (e)
1. Any property or service the value of which is so small as to make
accounting for it unreasonable or administratively impracticable
2. Free donuts, cokes, coffees
3. When you stay late at the office and get free meals
4. Special Rules for certain eating facilities - 132(e)(2)
a. An eating facility for employees shall be treated as deminimis
fringe if:
i. Such facility is located on or near the business premises
of the employer, and
ii. Revenue derived from such facility normally equals or
exceeds the direct operating costs of facility
b. Nondiscrimination in effect
c. Classic cases are hospital and studio cafeterias
vi. Qualified Transportation Fringe - 132(f)
1. Any of the following provided by an employer to employee:
a. Transportation in a commuter highway vehicle (CHV) if such
transportation is in connection with travel between employees
residence and workplace
i. CHV must seat driver and at least 6 adults, 80% of
mileage is in commuting and have at least passenger
b. Transit Pass
c. Qualified Parking
i. Must be at worksite or commuter drop off point for
carpool or (CHV)
2. Max benefit is $105/month for CHV and transit pass and $200/month for
3. No constructive receipt applies if take cash instead of benefit, pay tax
4. If reimbursed for parking, still tax-free
5. Not under this and still taxed on
a. Own private car
b. Your own commute
vii. Moving Expenses - 132(g), 217
1. Permits a deduction for moving expenses of the taxpayer and his
household in connection with commencement of work by taxpayer at a
new principal place of work
2. New work must be
a. At least 50 miles farther from former residence than wa his
former workplace
3. Taxpayer must be full time employee for a significant period of time
(generally 39 weeks)
4. Moving expenses include:
a. Cost of moving household goods from former resident to new
residence and
b. Cost of traveling (including lodging) from former residence to
new residence
viii. On premises Athletic Facility - 132(h)(5)
1. Use of an employer-provided athletic facility is not income if it is
a. Located on premises of employer
b. Operated by employer; and
c. Substantially all the use is by employees and their spouses and
dependent children
i. Qualified Pension Plans
i. When you take the money out, youre fully taxed on it
1. If you take it out early, you are penalized an have to pay tax on it
ii. Selected Rules of 401(k)
1. Elective deferrals
a. Up to $13,000/year (for 2003)
b. Limit will raise $1,000 per year to $15,000 in 2006
c. Even if couldve gotten cash instead, money in 401ks are tax-free
2. Matching contributions from employers
a. Not subject to annual limit
b. Not treated as elective contributions
3. Amount in plan may not be distributed without penalty except at
a. Death or disability
b. Retirement at age 59 or older
c. Subject to various restrictions can be taken out for
i. Certain medical hardships
ii. Purchase of principal residence
iii. Tuition payments
iv. Prevention of eviction from ones home
4. Must not discriminate in favor of highly compensated employees
i. But may have benefits proportional to compensation
ii. Policy: want to make sure the poor are allowed to have a
decent standard of living, so giving rich more wont help
5. Max annual benefit is lesser of
i. 100% of employees average compensation for his highest
3 years, adj. for inflation OR
ii. $160,000 (in 2001, adj. for inflation annually)
6. Max annual contribution is lesser of
i. 25% of annual compensation OR
ii. $40,000
7. Taxpayer is permitted to borrow from plans
i. Max is lesser of $50K or half of the current value
ii. Larger amounts may be borrowed for things like down
payment on first home
8. Planning: Borrow from equity in your home and not from pension
a. Get a mortgage, pay tax free interest on that and collect tax free
interest in pension
9. IRAs are only better than 401ks when you plan ot taking the money out

j. Imputed Income
i. The untaxed economic benefit from the use of ones own property and ones
own services
ii. Rental vale of condo is not taxed
iii. Policy: Fundamentally unfair people are in the same circumstance, but people
who own a house, doesnt pay tax on their living situation, but people who rent
and invest difference pay taxes on that
iv. But Tax advantages of any investment will be built into the price of the
v. Policy: Taxes encourage people to do things themselves that wouldnt be the
most efficient way to do it
1. If would be better to work rather than clean, maybe wont if have to pay
taxes on income of work and not on cleaning your own house.
2. Higher tax rates are more likely to discourage the work behavior of
secondary earner women than any men or single women
3. The more younger children the more value you can produce at home
cost a lot to replace your effort
4. Alternatives around policy implications
a. Allow to file as two singles
i. But it would be a tax increase for single men and married
b. Use to be a law that allowed lower earner to reduce income by
c. Also to have more deductions for people who work like more
child care deductions
k. Who should buy a home and who should rent?
i. High bracket itemizers should buy
ii. Low bracket should not buy
iii. Prices of homes have the tax advantage accounted for so you need to itemize
in order to take advantage of it and get your moneys worth
iv. Effects on the $1.1M deduction of interest
1. Price Effect Homes more than $1.1M would drop in price because
there are no tax advantages above the price
l. Externalities
i. When private costs or benefits to producers or purchasers of a good or service
differs from the total social cost or benefits entailed in its production or
ii. Traffic Example How do you reduce traffic through taxes
1. Tax Gas Europe way
2. Tax Cars but number of cars isnt the problem, its the amount that they
are driven thats the problem
3. Tax actual miles
4. Charge for going into city center
a. Dramatically reduced traffic in London
5. Future use GPS system to determine where they are going and tax
them accordingly
iii. Optimum Social Policy
1. Tax everything its externalities
2. Then do things that help out distributional effects in it
a. Help poor with extra money
3. Then this will help some poor people (who already take public
transportation) and hurt others (those who have to drive during peak
iv. Positive Externality
1. Guy paints his house, it benefits his neighbors
v. Negative externality
1. Guy makes his house look crappy, it harms value of neighbors house
vi. Taxing Externalities Congestion Tax
1. If you give everyone a check and then tax driving during rush hour then
everyones better off
2. Those who dont drive
a. Keep the money
3. Those who do drive
a. Less congestion on the road
m. Haig-Simons Income
i. Haig-Simons Income = Consumption + Change in Wealth
1. Y = C + deltaW
ii. Should be taxed on what was consumed plus how much wealthier you are
during the hear
iii. Change in wealth includes appreciation of assets
iv. This isnt the law but it accurately reflects what every person earned

n. Windfalls and Gifts

i. Commissioner v. Glenshaw Glass
1. Everything is taxable unless theres a provision to the contrary in the tax
2. Punitive Damages are taxable
ii. Gifts
1. Detached and disinterested generosity . . . out of affection,
respect, admiration, charity or like impulses
2. Not taxable
3. Not deductible by the donor
iii. Commissioner v. Duberstien
1. Gift out of clear business motivation is not truly a gift
iv. Business Gifts - 102(c), 274(b)
1. Precludes gift treatment for any transfer by and employer to an employee
a. Modest achievement awards under 74
b. De Minimis fringe under 132
2. Limits deduction for business gifts to $25 per recipient per year
a. Exception: Imprinted items worth less than $4 and promotional
materials to be used on the business premises of the recipient
b. Firm can deduct up to $25 and the recipient wont have to report
i. Its because IRS knows that no one would ever report it
3. Employer Employee Employer deduction, employee taxable
(Except for exceptions above)
v. United States v. Harris
1. Gave gifts to mistresses - $500K over the years
2. Tried for criminal tax evation. IRS had to show
a. They werent gifts
b. Harris knew they werent gifts and intentionally chose to violate
3. Were these gifts?
a. Examine DONORs intent
i. Cant use Tax return to show it, but could use letters
written by donor
vi. Gift Tax
1. Each individual can give away $11,000 per year per recipient completely
tax-free (Joint returns can give $22K/yerar/recipient)
2. If more, DONOR pays the gift tax
3. Planning: Give $11K/year to each person you want to get your money
vii. Income Tax Treatment of Gifts
1. Basis is transferred with Gift
a. If gift was stock bought at $1000 that was now worth $2000, the
basis for receiver is $1000
b. Rule in Taft v. Bowers
2. If at time of gift FMV > basis
a. Recipient gets donors basis
3. If at time of gift FMV < basis
a. If gain on subsequent sale
i. Recipient gets donors basis
b. If loss on sale
i. Basis is same as FMV at time of gift
c. If you sell higher than FMV at gift and lower than basis theres
no gain or loss

o. Transfers at Death
i. 102 Bequests are tax-free to beneficiary
ii. 1014 Basis of property acquired by reason of death is the FMV at the time of
death (or optionally, 6 months after death)
iii. Planning: Sell losing stock before you die, keep gaining stock until after you die
because bases are adjusted
iv. Planning: Sell equal amount of winners and losers of stock during a year to pay
not cap gain taxes on it
1. Then keep all the winners until you die so the basis will change
2. Youll never pay tax on the gains of yoru stics
v. Policy: Because people shiled income from capital like this Acutal tax rate on
return of capital is about 5%
1. Middle class doesnt pay much tax from capital because most is in home
mortgage deduction and 401K
2. Rich do the above
3. Poor dont get these benefits
vi. If Estate tax is repealed
1. Would still have the readjustment of basis up to $1.3M
2. But if its more than $1.3M, then would have to
a. Figure out the carryover basis by
i. Determining price of home, and capital improvements
b. Now it would just be the FMV at death

p. Transfer of Property with Unrealized Gain or Loss

i. 1001 Gain is the excess of the amount realized over the adjusted basis
1. Gain Realized = Amount realized Adjusted Basis
ii. When you sell something with improvements, add the cost of improvements to
adjusted basis
iii. Policy: Goal is to get a fair and accurate reading of what the gain is
q. Estate Tax
i. Bushs Plan
1. Unlimited exclusion from Estate tax in 2010
a. In 2011, goes back to $1.5M and 50% tax on that
ii. Unified Credit
1. Its the exclusion of estate tax minus what theyve given away during
their life time
2. Ex: If they have $1.5M exclusion and give away $500K during life, then
their unified credit is $1M
iii. Policy: Elimination of Estate Tax
1. Do it because
a. Its complicated and doesnt raise too much revenue, so might as
will cut it
b. Should only have to pay taxes when you are enjoying your
income, and when it is finally spent it will be taxed but this
requires consumption tax
c. Its just not fair, its double taxed because income was already
i. But youre always taxed twice because you have sales tax
already on stuff you pay with for taxed money
2. Dont do it because
a. It would only go to rich folks, and the countrys broke, so keep it
b. The amount of income is a better indication of what you can pay
then the amount of consumption
iv. Changes under EGTRRA of 2001
1. Exemption increases from $1M to $3.5M from 2002 to 2009
2. During same period, top rate goes from 50% to 40%
3. 2010, no estate tax at all
4. 2011, Estate Tax is reinstated
5. Scary stuff
a. 2009 top rate is 40%
b. 2010 top rate is 0%
c. 2011 top rate is 50%
d. A lot of encouragement of Death in 2010
r. Consumption Tax
i. Two types
1. Pure - It would account for everything you consume but would add rental
value of your home
2. Never tax any investment returns, tax no income from property, ant the
same time no deduction for any interest payments
ii. Current System is a mix of Income and Consumption Tax
1. 401(k)s are taxed on when used consumption
2. Most everything else is taxed when received income

s. Recovery of Capital
i. Components of it
1. Adjusted Basis What you pay for it
2. Amount Realized What you get for it
3. Gain Realized What your taxed on
a. Amount Realized Adjusted Basis
iii. Depreciation
1. Used on assets that will likely decline in value over a predicted use of
2. Tax code divides assets into certain types and decides how many years
property of that class is going to last
a. Most things are given a 5 year useful life
iv. Types of Depreciation
1. Straight-line
a. Deduct and equal amount of the cost during each year of its
useful life
b. i.e. for $10K printing press w/ 5 year life it would be deduction
of $2K for each of the 5 years
c. Some property can only be depreciated this way like value of
2. Amortization Describes depreciateion of intangible assets like patents
and trademarks
a. Usually straight-line over assets usual life
3. There are others, but wont need to know them for the class like
accelerated depreciation more in the beginning
v. Adjusting Basis
1. Decreases assets basis by the amount of depreciation or amortization
a. Even if you forget to take the deduction for business expense
purposes, your basis still adjusts
2. Adjusted Basis = Purchase price Depreciation
a. i.e. Bought for $30K, last 10 years; 3 years later adjusted basis is
b. If you sell that fro $35K in year 3, gain will be $14K (35-21)
3. Basic Principle: Tax the difference between the amount received and the
adjusted basis
4. Depreciation Recapture Rule: Any depreciation you took, if you make
income on it later, must be taxed at the income rate.
5. Special Rule: The first $100K of equipment usually appreciable, can be
deducted immediately as a part of Cost of Goods Sold
t. Partial Sales
i. Sale of partial lands are Basis of All parcels * (Value of Sold/Value of All
1. 6 acres bought at $6K. Sold 3, then basis is $3K but only fi theyre
similarly valued acres
ii. If they are different then the basis depends on what acres are sold
1. If the valuable ones are sold, then the basis is based on them
iii. Inaja Land v. Commissioner
1. Should money received from sale of damaged property be recovery of
capital or gain?
2. In this case, LA pollutes their river and have to pay $50K to release
liability for pollution
a. Legal fees are $1K, so gain of $49K
3. Basis was $61K
4. Said it was tax free
5. Based on two factors
a. Basis allocation in the case would be difficult
i. But today wouldve had experts maybe deciding what
cost of polluted land was when it was bought
b. Sale was involuntary
iv. Sale of oil rights
1. Should recover a percentage from the basis each year
a. Like depreciation

u. Life Insurance
i. Two Types
1. Whole Life
2. Term Life
ii. Whole Life
1. Has two elements
a. Term Insurance Element
b. Savings Element
2. Tax Treatment
a. Taxed like a 401(k) the buildup of interest is not taxed until
b. And only taxed on the gain
c. And if withdrawn as death benefit its never taxed
3. What you can do with savings portion of it
a. Use for retirement
b. Use to buy more death benefits
4. Not a great deal because the companies take huge cuts
iii. Term Life
1. Provides the purchasers heirs with cash death benefit in the event of
the purchasers death
2. Tax Treatment
a. Amount received as a death benefit generally are excluded form
taxation under 101
b. Life Insurance premiums generally are not deductible
c. Why is it done this way why not deduct premiums and tax
i. Too complex
ii. It seems unseemly to tax when relative dies
1. People buy life insurance because death causes
financial loss so shouldnt tax them on it
2. Also the one time payment will be taxed high, but
there wont be any income later so its not really a
fair tax
d. Employer provided life insurance
i. First $50,000 of benefit is tax-free to employee
1. But non-discrimination rules must apply
ii. If more, employee would be taxed on it
3. Fairness
a. Its actuarial fir when the premiums coming in would equal
benefits going out
b. In real world, not the case because companies have to cover
expenses and profits
iv. Policy Free market doesnt work for insurance
1. Bad insurance companies dont work under the free market because
really dont know if its a good insurance until you really need it
2. But you can evaluate term life better because all that it is what you pay
in and what youll get out
3. Whole life is harder to figure out
a. Because it promises you money for retirement
4. If you do get a fair return on whole life, there are a number of tax
v. Annuities
i. Contractual right to receive payments for a fixed item or for the life or lives of
some person or persons
ii. 72 - The purchaser of an annuity is not taxed until payment is received. Each
payment consists partly of return of capital and partly of income earned. The
portion taxes is calculated as:
1. Exclusion Ration - A percentage of each annuity payment is excluded
from taxpayers gross income. The rest is taxed
2. Once the total excluded payments equals the taxpayers investment in the
annuity, all additional payments are included in income
3. If taxpayer dies before recovered all of investment, shes granted a
deduction for the amount of unrecovered investment
iii. Exclusion Ration
1. Investment in annuity/total expected payments
2. ex: Purchases annuity at age 70 for $100K. Pays her $10K/year for life.
Expected to live 15 more years. So expected payments are $150K
a. Exclusion Ration is: 100K/150K = 2/3
b. So 2/3 of each payment is not taxed and 1/3 is
c. If she dies in year 10 50K has not been deducted so estate can
deduct 50K as unrecovered investment
iv. Tax advantages of annuities Deferral
1. No tax is paid unless payments are made, even though the investment is
increasing in value each year
2. Taxable gain on the annuity is assigned equally to each payment received
even though the actual gain is hither in early years and lower in later
v. Planning Buy Annuities or not?
1. Buy them
a. Allows you to guarantee payment stream that would last as long
as you live
i. Wont have any left over or wont run out
b. Important tax advantages discussed above
2. Dont buy them
a. Insurance companies will try and cheat you but shop around to
avoid it
b. Annuity pays you for the rest of your life so real healthy old
folks buy them
i. Its adverse selection insurance companies cant use
normal life expectancy charts so they move the average,
since only customers are in healthy category
w. Gambling
i. Winnings are fully taxable
ii. Losses can be deducted against winnings during the same taxable year
1. But those losses are deductible only as itemized miscellaneous
2. Thus, one is required to report winnings even if one is a net loser for the
iii. Gambling expenses, such as travel expenses to tournaments are only deductible
for professional gamblers
iv. Comps are treated as gambling winnings
v. Reporting Requirements W2-G
1. Payer must issue a W2-G if winnings are
a. $600 or
b. 300 times the amount wagered
c. This applies to winning events such as dog racing, horse racing
and state lotteries
i. Also Casino games like Let it Ride
2. For Bingo, Slots, or Video Poker must be issued for a win in excess of
3. For Keno have net proceeds greater than $1,500
4. Table Games Winnings are not reported
vi. Planning
1. In theory youre supposed to keep track of your sessions and report
winnings as income and losses in miscellaneous deduction
a. Good policy would just to combine the income and losses
2. Deductions do NOT affect the Alternative Minimum Tax
3. Miscellaneous deduction subject to a 2% floor
4. As a professional
a. Need to show you have an intent to make money
b. IRS wont believe you if you dont have not winnings or only
play on the weekends
c. The more fun something is, them more burden of proof is that
youre a professions

x. Recoveries for Personal and Business Injuries

i. 104 Compensation for Injuries or sickness; income does not include
1. Workmens compensation for personal injuries or sickness
2. Damages received on account of physical injuries or physical sickness
a. Punitive damages still taxed
3. Amounts received through health or accident insurance for personal
injuries or sickness (if premiums were paid for in after-tax dollars)
a. If paid for with tax deducted premiums then benefits are taxed
4. Pensions received for certain disabilities such as those due to injuries in
5. Amounts received disabilities by US employees arising out of terrorist
attacks IN FOREIGN countries.
ii. Additional Rules
1. Emotional distress is not a physical injury. However, recoveries for
emotional distress may be excluded from gross income up to the amount
of medical expense incurred as a result of emotional distress
2. Punitive damages in a civil wrongful death action can be excluded from
income IF, under stat law, its the ONLY award available in such an
iii. Attorney Fees for Taxable Recoveries
1. Taxpayer must take into income the full recovery, including attorneys
2. Can deduct attorneys fees in miscellaneous deduction
a. But subject to the 2% floor
b. And are not deductible for the AMT
3. Special Rule awards for employment, whistle blower, and civil rights
litigation do not count attorney fees and court costs as taxable income
iv. Structured Settlements
1. Interest earned on damages is taxable
2. BUT if tax-free injury settlement is paid over time, then the entire
recovery is tax free, even if theres implicit interest for the delay
3. Using a set of complex transactions with an insurance company, the
tortfeasor business may be able to obtain an immediate deduction
4. Example
a. 2 choices - $100K now, and then you put in annuity that pays
$15K/year for 10 years. Or can get $15K/year for 10 years
i. Annuity will be taxed like annuity
ii. Payments will never be taxed on it
v. Policy
1. What should be taxed?
a. Lost wages?
b. Medical Expenses?
c. Pain & Suffering?
d. Punitive Damages?
2. Under the Law for physical injuries Lost wages, Medical Expenses,
and Pain & Suffering is tax free
3. Policy wise what should be taxed?
a. Lost Wages
i. TAXED - Should be because you would be taxed on it
anyway if you made it as wage
ii. If it were tax free, then victim would be better off had
they not been in the accident
b. Medical Expenses
i. TAX FREE To completely compensate the victim had
he not been in accident wouldnt be any medical expenses
c. Pain & Suffering
i. Depends on theory of taxation
1. Tax by financial well-being. Persons should be
taxed on their ability to pay
2. Taxed by overall well-being Persons should be
taxed on how well off they are
ii. These people are better off financially, but not on overall
iii. Utilitarian would TAX because they want to maximize
total welfare
1. Higher marginal value of money should be higher
2. But theres no higher value of money between the
pain and suffering and a normal person because
money cant do anything about the P&S
3. But its OK to give deductions for medical
expenses because the money will actually help
their well being
d. Punitive
i. TAXED does not represent any loss, only represents
windfall gain to recipient
ii. Counter argument If we think punitive damages are an
encouragement to sue, then to encourage law suits we
should make them tax-free
vi. Accident and Health Plans - 105
1. Include in income if attributable to contributions by employer (or to
deductible payments by employee)
2. However, amounts received under accident plans are NOT included if
such payments are reimbursement for medical expenses for the taxpayer,
her spouse, or dependents, unless the medical expenses previously were
deducted by taxpayer
3. Payments for the permanent physical impairment of the taxpayer, spouse
or dependent are also excluded from income if the payments that are not
related to period of the absence from work
4. Ex: An insurance policy pays $50K fi they lose a hand is tax free
vii. Insurance Provided by Employer
1. 106 Employer-paid medical insurance and contributions to certain
medical savings accounts is not included in employees income
a. Employer can deduct
y. Use Tax
i. The reporting of the difference in sales tax between your state and other states
1. Do it by reporting prices of stuff you buy from other states
ii. Policy good and bad law
1. Bad law because No one keeps track of what they bought out of state
2. Good law because itll stop businesses from going to other states and
buying stuff and paying no sales tax
3. Make it better by making an exemption of first X$s so wont penalize
individuals who dont keep track and still penalize businesses

z. Forgiveness of Indebtedness
i. Loan Proceeds are not income and loan payments are not deductible
1. Applies to both:
a. Recourse loans: Borrower is personally liable
b. Nonrecourse loans: Borrower is not personally liable
i. CA law makes original loan for home purchases to be
ii. Can only take the house, not any other assets
iii. But refinancing are recourse can take other assets
2. Haig-Simons consistent because increase in consumption is offset by
lowering of wealth
3. Consumption Tax treatment would be tax principal when received and
deductible when paid
ii. Discharge of indebtedness
1. Individuals are taxed on the discharge of indebtedness
2. United States v. Kirby Lumber
a. Issues 1M in bonds repurchases them later for $862K
b. The $148K difference is considered taxable income
iii. Transfer of Property Subject to Debt
1. Amounts borrowed are included in basis and may produce depreciation
2. If property subject to a liability is transferred to another, the discharge of
debt is treated as part of purchase price
3. Ex: Alan borrows $500K interest only loan to buy property; depreciates
at 20K/year (business property cant depreciate personal property)
a. If in year 8 he abandons property, still oweing $500 but already
depreciated 160K then theres adjusted basis of $340K; and
gain of 160K
4. Planning Current law encourages more sales of new homes
a. Because you can exclude first $250K gain on sale of residence,
the more homes you sell in period then the more non-taxed gain
youll have
i. But there are restrictions to how often you can do seen
b. Two examples
i. Over 10 years, bough house at 500K, sold at 1.5M taxed
on 500K if married; 750K if single
ii. Over 10 years, bought house at 500K, sold at 1M, bought
another at 1M sold at 1.5M taxed on 0 if married; 500K
if single
5. Commissioner v. Tufts
a. The assumption of a non-recourse mortgage constitutes a taxable
gain to the mortgagor eve if the mortgage exceeds the fair market
value of the property

aa. Illegal Income

i. General Rule: Illegal Income is taxable and expenses associated with earning
illegal income (with few exceptions) are deductible
ii. Gilbert v. Commissioner Exception to general rule
1. If there was always an intent to repay the unauthorized corporate
withdrawals and he thought he was acting in the best interest of the
corporation (he told the board of his intentions), then its not taxable

bb. State and Municipal Bonds

i. 103 Interest on state and municipal bonds is not subject to federal income
1. So states and cities can borrow money more cheaply
ii. Does this violate horizontal equity?
1. Yes because taxpayers are in the same position pay different taxes
2. No the return of state and municipal bonds will be less than corporate
bonds because the tax exemption will be accounted for.
iii. Definition Putative tax The difference between the interest rate paid on
taxable bonds and the rate on municipal bonds
1. i.e. Corporate pays 12%; Muni pays 9%; Putative tax is 25%
iv. Policy Taxpayers with an high tax rates will buy helps the rich
1. Taxpayers with actual tax rate higher than putative tax rate will buy
2. Example 3 different types of people 40%; 30%; 20% tax rates
3. If corporate bonds pay 10%, who will benefit from muni bonds at
a. 6.1% - only people in 40% tax rate would buy
b. 7.1% - only people in 40 and 30 tax rate will buy
4. States are the ones who benefits
a. People buy their bonds at a lower interest rate
b. Federal Government loses the 30% tax they wouldve gotten had
they taxed them
c. Just like a transfer from Fed to state
i. But some people saves more than state benefits because
their tax rate is much higher than the putative tax
5. Why not have a direct transfer from fed to state?
a. States dont want to risk making it political and depending on
b. Federal government likes that its off budget its more small
government to have it off the books
v. Limitations on Issuance of tax-exempt bonds
1. Unlimited tax-free bond may be issued for traditional government
purposes like school and parks and roads and sewers
2. Other bonds called private activity bonds generally not tax exempt
3. Some forms of private activity bonds are tax exempt
a. Exempt facility bonds used for airports, docks, mass transit,
water and sewage
b. Some bonds used for low and moderate income housing
c. Certain bonds for charitable purposes
4. There are, however, limitations on the amount of private activity bonds
that can be issued by state
5. Interest on private activity bonds may be subject to alternative minimum
tax, and thus not truly tax-exempt
6. Regulations prevent states from engaging in tax arbitrage borrowing
money tax-free and reinvesting the money at higher rates

cc. Gain on Sale of Home - 121

i. Basic Rule: Gross income does not include gain from sale or exchange of
property IF
1. During the 5-year period ending on the date of the sale such property has
been owned and used as taxpayers principal residence for period
aggregating 2 years or more
ii. Limitations
1. The amount excluded cannot exceed $250K (or $500K on joint return)
Only one spouse needs to meet ownership requirement
2. The exclusion does not apply to a sale if, during the 2 year period ending
on the date of the sale, there was another sale to which the exclusion
3. Relief provisions permit a smaller exclusion if the taxpayer cannot meet
the 2 year occupancy or one every 2 years requirement because of a
change in health, employment or certain unforeseen circumstances
iii. Policy Why 5 year own; 2 year live
1. If you leave for a job and rent it out, you still can deduct the gain
iv. Capital improvements increase the basis cutting into the gain
1. Repairs dont, that just replaces broken stuff

IV. Timing Problems

a. Recognition of Losses
i. 165(a) There shall be allowed as a deduction any loss sustained during the
taxable year and not compensated for by insurance or otherwise
ii. 165(b) Amount of loss = Adjusted basis of property
iii. A loss will not be recognized simply because property has declined substantially
in value
iv. Rather, a loss must be evidence by a closed and completed transaction, fixed by
identifiable events
1. A loss will be recognized if property is sold, exchanged, or abandoned
2. A loss will be recognized in the year property became worthless
v. Revenue Ruling 84-145
1. Cannot take a loss for decreased value of airline routes until abandoned
as worthless
2. Policy issues:
a. Why allow the deduction?
i. There is no market for the airline routes because of
deregulation its as if its been made worthless
b. Why not allow it?
i. Cant identify the exact amount of loss
vi. Must deduct worthless stock in the year it becomes worthless
1. Have to take deduction when youre entitled to take it
b. Original Issue Discount
i. Theres no stated return, so its difficult to tax
ii. General Rule: 1273 interest will be imputed and taxed annually if there is no
(or inadequate) stated interest on a loan
iii. Policy Debate 3 options
1. Tax the bond like a growth in stock or real estate only on sale
a. Gain would only be taxed in last year when sold
b. Taxed at capital gain rates
c. And if died, wont ever pay taxes on it
2. Tax bond like savings account
a. Impute annual interest and tax it annually
b. Pay taxes on it every year will make the total return lower (if
10% return in 35% tax rate the after-tax return is 6.5%)
c. This is the law
3. Compromise Tax gain on bond at end at ordinary rates
iv. Policy Debate Continued
1. Consumption tax people shouldnt tax investment returns at all
2. Haig-Simons everything should be taxed like #2
a. If increase wealth, should be taxed
3. In todays world we tax savings account more harshly than land and
a. Option 1 above is land; option 2 is savings
4. IRS things bonds with no stated % are like savings accounts because its
a fixed guaranteed return thats easy to calculate
v. Classic Case: Buy a Zero Coupon Bond
1. A bond you dont get interest on each year
2. Theres a hidden interest rate and easy to calculate
vi. OID and Sales of Property
1. When money is agreed to be pay after the transfer of property.
a. Ex: Cynthia agrees to purchase GA from Troy. Price is $1M to
be paid in 10 years.
b. Under OID rules, this will be treated as if she purchased GA for a
lesser amount and then paid interest on that amount for 10 years
2. Imputed interest rate is a federal rate that varies according to current
market conditions.
a. Lower Rate Higher Purchase Price
3. Basis is the Present Value of the payment not the amount of the
vii. Exceptions to OID
1. Tax-Exempt Obligations
2. Obligations under 1 year
3. Loans under $10K between natural persons
4. Sale of principal residences
5. Sales of farms for less than $1M
6. Sale of property for payments totaling less than $250,000
7. 453 however generally will apply to these transactions and ensure
that interest is taxed as ordinary income rather than capital gain, even if
interest is not imputed annually.
a. Option 3 above

c. Open Transaction and Installment Sales

i. 453B The portion of each payment that should be included in income as gain
from the sale is: Gross Profit/Contract Price
1. Gross Profit = Selling Price Adjusted Basis
2. Contract Price = Selling Price Debt Assumed by Buyer
ii. Open Transactions
1. Its Open when the payments are uncertain like it is based on mineral
rights that are not known yet
2. Three possible ways to tax it Burnet v. Logan
a. Treated as Closed Transaction (pro-IRS)
i. Apply Gain Realized Rule
ii. Amount realized would be cash received plus present
value of receiving the payments
iii. Immediately taxed on the Gain Realized
b. Treated as Open Transaction (pro-taxpayer)
i. Dont know how much payments shes going to get, so
wait until she finds out
ii. Not taxed until total of the payments exceeds bsis
c. Installment Method (Current Law)
i. Allocate some portion of basis to each payment received
iii. Notes on Installment Sales
1. Installment Sales are a rare case where debt discharge is not treated
exactly like cash received
2. The installment sale rule applies to most sales where at least one
payment for the property will be received after the close of the taxable
year in which the sale occurs
3. The installment sale rule does not apply to
a. Publicly traded property such as stocks and bonds on a public
b. Credit Cards - Revolving charge accounts for sales of personal
c. Sale of inventory sold in normal course of business
d. Depreciation Recapture
i. When you have depreciated property and then later you
sell the property for a gain, the gain on property sale is
taxed on ordinary income
e. The open transaction method is not available to taxpayers.
Rather, uncertain payments must be estimated

d. Constructive Receipt
i. If taxpayer has an unrestricted right to income she is taxed on the income even if
they have not physically received it.
1. Exception to the cash based taxpayer not taxed until paid
2. Accrual is taxed on income when it is earned, even if not collected
a. Its more accurate way to determine how a business is doing
ii. Amend v. Commissioner
1. Under contract that was signed, taxpayer did not have right to money
until 1945 so should be taxed in 1945
a. No evidence of tax avoidance purpose
2. The farmer consistently delayed receipt of payments this way throughout
his career
a. If he hadnt, IRS couldve applied 446(b)
i. Allows IRS to impose a method of accounting if the
taxpayers method does not clearly reflect income
iii. If you receive a check and not cash it until the next year you are taxed in the
year you receive it
iv. Notes on Constructive Receipts of Wages
1. Payment to employees are not deductible by the employer until the
payments are taxable to the employees. This is true even if employee is
cash basis and corporation is accrual basis 404(a)(5)
a. Ex: Year 1 Work Done; Year 2 Paid
i. For financial accounting business expense deduction
taken in year 1
ii. But this rule overrides this, they cant take deduction until
employee takes income; so since employee is cash basis
wont take it until year 2, so employer cant take it until
year 2
iii. Planning They need 2 separate bucks accrual basis
one, and one for taxes that considers these payments in
different years
2. Policy: If employee and employer in same tax bracket, total tax received
will be the same regardless; but if employer is tax-exempt (like a charity)
then timing affects the total tax burden
3. Amend under current law:
a. Installment sale rules would apply. Thus Amend would report
income in 1945 when he received the payment
b. If Amend opted out of installment treatment, he would be taxed in
1944 under treasury regulation which treats receipt of an
installment obligation as the receipt of property in an amount
equal to the FMV of the obligation
v. Ex: Offered signing bonus of $1M at end of 5 years
1. Team bought $600K annuity for in players name, worth $1M in 5 years
a. Taxed on amount of annuity in Year 1; and then again in year 5
on the gain
2. Team contributes $600K to trust fbo player, that pays $1M in 5 years
a. Same as #1
3. Trust fbo Corporation and then $1M paid to player in year 5
a. Taxed on $1M in Year 5
b. But if team goes belly up, creditors get the trust
4. Contract for it, owner signs as a guarantor
a. Taxed in Year 5
b. Protected unless company and owner go bankrupt
5. Corporation sets up 401(k) for him?
a. Cant do that because cant collect 401(k) until retire
b. And there are contribution limits on it
c. And wont meet non-discrimination rules
vi. Commissioner v. Olmstead
1. Facts
a. Olmstead had right to commissions based on prior sales for
Peoples Life Insurance
b. At Peoples request, he exchanged his right to future commissions
for fixed payment annuity of $500/month for 15 years
c. He couldve taken cash, but preferred an annuity
i. If that happened, he wouldve been taxed when he
actually received the payments cash basis
2. IRS claimed that he traded property right for annuity so should be taxed
on Gain Realized
a. Which was 68,000, because adjusted basis of commission rights
is 0 because he was entitled to them because of labor
3. Court holds: Not taxed on value of annuity
a. Was a cancellation of old payment structure and a replacement
with a new payment structure rather than a taxable exchange of
property under 1001
4. Policy doesnt make sense to tax it
a. Doesnt have the money to pay the taxes
b. Theres no abuse going on hes worse off now
c. The obligation is still coming from the corporation, theyre still
promising to pay Olmstead
d. If we did tax him and knew it, then he wouldnt have accepted
the deal, which would discourage corporation to restructure its
commission annuity policy because it would be inefficient
5. Treat this like a novation ripping up the old contract and making a new
a. So shouldnt be taxed on it.

e. Qualified Employee Plans

i. Three things happen
1. Employee is given stock options
2. Employee exercises stock options
3. Employee sells stock
ii. How to tax? 3 ways
1. Tax when receive the option
a. Tax as Part of Income in Year 1 (Employer gets matching
deduction). Basis is value of option
b. No tax when exercise.
c. Cap Gains on sale of stock basis is exercise price + option price
d. Problems with this
i. May not have the money in year 1 to pay the tax
ii. Option has unclear value in year 1 because may lose it if
she is fired before exercising it
2. Tax when exercises the Option
a. No tax when receive it
b. Exercise: Tax on difference between FMV and exercise price as
Income. Basis is FMV (Employer gets matching deduction)
c. Sale: Cap Gains on sale
d. Good about it
i. Dont have to figure out how much the option is worth
ii. Dont have to worry about forfeiture because shes taxed
on it after exercise
iii. Shell have the money, but ONLY if she sells stock
e. Problems with it
i. Forces her to sell the shares
3. When she sells the stock
a. Receives tax-free
b. Exercised tax free. Basis is exercise price
c. CG on sale of stock (Employer never gets deduction)
4. All these methods are used in different circumstances
iii. Incentive Stock Options (ISO) - 422
1. Apply Option 3 Cap Gains on the sale
2. They need to be explicitly states ad Incentive Stock Options
3. Requirements
a. Employee must retain for 2 years after option grant and 1 year
after exercise
b. Exercise price must be no less than FMV of stock at time the
option is granted
c. $100K limit on value of stock subject to unexercised option
i. The total FMV of stock you can purchase has to be below
4. Low ceiling makes ISO of little importance to highly paid executives
iv. Nonstatutory Stock Options - 83
1. Same tax rules as all other property received for services
2. FMV included in income in the year the property is received
a. Option 1 above
3. Exception 1 If property is subject to a substantial risk of forfeiture
which means rights to full enjoyment of such property are conditioned
upon the future performance of substantial services by any individual
a. Can elect 83 treatment OR
i. Tax to income when property becomes nonforefeitable
b. Most employers choose to the 83 treatment. Why?
i. Can lowball the value these are private companies and
no one knows what the shares are worth
ii. Taxed a tiny amount in income, and when they exercise
the option it will be at capital gain
4. Exception 2 If option has no readily ascertainable FMV
a. Employee is taxed when option is exercised
b. Policy: Its to prevent taxpayer from making the 83 election and
then grossly undervaluing the options
c. Treasury regulations provide generally that options not traded on
an established market have no readily ascertainable FMV
5. Summary
a. If options have readily ascertainable FMV then either:
i. If no risk of forefietire or 83 election option 1
ii. If risk of forefeiture and no 83 election option 1 when
risk of forefeiture lapses
b. If options have no readily ascertainable FMV option 2

f. Stock Options
i. The money you pay for the option gives you the right to buy stock at a certain
price within a certain time frame
ii. Basis = Exercise Price + Price of Option
iii. Amount Realized Price of stock when you exercise the option

g. Transfers Incident to Divorce

i. 1041 No gain or loss shall be recognized on transfers of property
1. to a spouse (in any case) or
2. to a former spouse if related to a divorce or separation
a. Transfers within 1 year after the date of dissolution are deemed
incident to divorce
b. After the 1 year period, the taxpayer must show that transfers are
incident to divorce
ii. Pre Nuptial Settlements
1. Farid-Es Sultaneh Case
a. H transferred $800K (Basis $12K) in stock before marriage in
exchange for Farid releasing all rights in event of divorce
b. Couple divorces and she eventually sells stock for $1.5M
c. Court says the basis is $800K because it is a purchase
i. She offered fair consideration for stock, and even though
it may have been taxable as a gift, this is not conclusive as
to whether it is a gift for tax purposes
d. IRS got screwed because statute of limitations ran out and
couldnt demand tax from H for the exchange.
2. To avoid taxation in the future, make the transfer after they get married
all transfers to spouse are tax free
a. If worried about dying before marriage, get an insurance policy
iii. Alimony, Child Support, and Property Settlements
1. Alimonys deductible to payer; taxed on recipient - 71(a); 215
2. Child Support are nondeductible by payer and nontaxable on recipient
3. Policy: IRS would rather have alimony be taxed because people paying it
usually are in higher tax bracket then receiver
4. Alimony requirements:
a. Payments are in cash
b. Payments are received by spouse under a written divorce or
separation instrument
c. The instrument does not designate such payments as not
includible and not deductible under 215
d. The payer and payee do not life together
e. There is no liability for such payments after the death of the
payee spouse
5. Any payment that is contingent on factors such as the age, schooling, or
marriage of a child will be a child support payment and not alimony -
6. Cannot take a nonbusiness bad debt deduction if are unable to collect
child support
a. Diaz-Arguelles v. Commissioner
7. Bad Debt Deduction variations
a. Suppose husband borrows money and defaults?
i. Bad debt deduction
b. Husband borrowed and then dies penniless
i. Bad debt deduction
c. Promissory not as payment for child support due
i. Bad debt deduction
d. Sells not to 3rd party
i. No bad debt for her; but maybe for 3rd party

h. Theoretical Issues
i. Consumption Tax
j. Accounting Methods
i. Cash Method
1. Income is reported in the year it is received
2. Expenses are deducted in the year they are paid
3. Individuals who do not own their own businesses must use the cash
ii. Accrual Method
1. Income is reported in the year when all the events have occurred which
fix the right to receive such income and the amount can be determined
with reasonable accuracy
a. All Events Test
2. Expenses are deducted using the same test
3. Businesses that have inventories of unsold goods or material at the end
of the year must use the accrual method
a. The IRS requires all larger businesses to use accrual method
iii. 446
1. 446(a) Taxable income shall be computed under the method of
accounting the taxpayer regularly uses for financial reporting
2. 446(b) If the taxpayers accounting method does not clearly reflect
income, then the computation of taxable income shall be made under
such method as, in the opinion of the IRS, does clearly reflect income
3. 446(e) A taxpayer must obtain consent of IRS to change accounting
methods for tax purposes
iv. GAAP
1. Generally accepted accounting principals used in financial accounting
are usually used in tax accounting, but sometimes taxpayers are required
to apply different rules where GAAP leads to tax avoidance opportunities
2. Used especially when business does not accrue pre-paid income
v. Georgia School Book Depository
1. Collection is trivial to all events test especially when the debtor is
trustworthy and solvent
2. Facts
a. They were entitled to 8% commission after they distributed
books to schools
b. Depository never had title to the books
vi. Notes on Accrual of Pre-Paid Income
1. Dancing School Lessons Amount paid in advance for lessons are
accrued in year payment is made
2. Advance Baseball Ticket sales Amounts paid in advance for tickets are
accrued in the year the games are played
a. Here, we know when the games are going to be, in the dance
lessons we dont
3. Engineering Services - IRS cannot make you pay the first of either paid
or services performed
4. Appliance Service Contracts Amounts paid in advance for such
contracts are income in the year the service contract is sold, rather than
the year in which services are performed since it is unclear if or when it
will be performed
a. Extended warranties fall here
5. Magazine Subscriptions 455 income from prepaid magazine
subscriptions is accrued over the life of the subscription
6. Auto Club - 456 prepaid dues may be spread over the lifetime of

V. Personal Deductions, Exemptions, and Credits

a. Introduction
i. Deductions that are unrelated to the production of income
ii. May take in lieu of the standard deduction
1. Standard deduction for 2004 is $4850 for single and $9700 for married
2. Standard Deduction serves 2 purposes
a. Simplifies filing returns for individuals with only a small number
of deductions
b. Help reduces taxes on poor indiviuals
iii. Examples of Personal Deductions
1. Casualty Losses
2. Extraordinary medical expenses
3. Charitable contributions
4. Interest on home mortgages
5. State and local taxes
iv. Policy: Arguments for Personal Deductions
1. Some deductions define income more accurately as a measure of ability
to pay
2. Some deductions encourage socially desirable activity
3. Reduces tax burden of the working class by a greater percentage then it
reduces tax burden of rich
a. $3000 exemption to someone with income of $7000 reduces tax
burden 40%. Same exemption with income of $330,000 reduces
tax burden of 1%
4. More importantly, increases the income of the working class by a greater
percentage than increase the income of the rich
v. Policy: Arguments against Personal Deductions
1. Upside Down subsidies they are worth more to high-income taxpayer
because tax dollars saved by deductions are proportional to the marginal
tax rate
2. Poorer taxpayers dont itemize and get no benefit whatsoever from
personal deductions
vi. Policy: Very difficult to make a decision based on morals of redistribution
1. So should make decisions about personal deductions on
a. Accurately reflecting ability to pay
b. Encouraging desirable activities

b. Casualty Losses
i. 165(c)(3) deduction for losses from fire, storm, shipwreck, or other
casualty, or from theft.
ii. Hypos you receive a $5000 payment
1. Its counterfeit
a. Never counted in income
2. Was robbed on way to bank
a. Casualty Loss
3. Bought a Vase with it and was immediately stolen
a. Casualty Loss for FMV
4. Vase stolen 2 years later
a. Casualty loss for Lesser of
i. FMV or
ii. Basis
b. Fair because you never pay tax on the gain
5. Vase destroyed when car is struck on way home
a. Casualty Loss
i. A violent, immediate way of loss is considered other
6. Vase is destroyed when cat knocks it over in unexpected fit
a. NOT Casualty Loss thats what cats do, its normal
7. Vase is Counterfeit
a. Casualty Loss probably counted as theft
8. Your own arson destroyed the vase
a. NOT Casualty Loss if its your own fault, you cant take
deduction if youre grossly negligent or reckless
i. Can deduct a normal car accident
iii. More Hypos
1. Termites NO, its not sudden
2. Lose a Ring NO, not casualty loss, its just misplaced
3. Earthquake YES
4. Ring flushed down toilet by someone else
a. Debatable it needs to be sudden to be deductable
5. Lowering value in housing because of OJ Case
a. Temporary lowing in value is not a casualty loss
iv. How to take the Casualty Loss Deductions
1. 10% AGI Floor for taxpayers
a. And subtract $100 for each event
2. Businesses can always deduct their losses in the amount of FMV or basis
v. Policy: Is this good?
1. Yes: Same ability to pay if you dont count the income that moneys
2. No: Shouldve gotten insurance or protected it better

c. Medical Expenses
i. 213(a) - Medical expenses are deductible to the extent they exceed a 7.5%
AGI Floor
ii. Employer provided medical care is excluded from employees income without
any threshold
1. Self-employed individual can deduct 100% of premium paid for medical
iii. Policy Arguments for medical care deduction
1. Same ability to pay because the difference is the medical care
a. It assures that they are taxed the same
iv. Policy Arguments against monitoring
1. Some medical expenses have elements of personal consumption they
are voluntary
2. The medical expense deduction disproportionately benefits the wealthy
3. Shouldve got insurance
4. Invite fraudulent claims
v. Who gets the deductions
1. People with high uninsured medical expenses
a. Insured people dont get it
2. People who itemize
3. They tend to be
a. Disabled people who arent covered
b. People in psychiatric care usually not insured and relatively
vi. Whats covered
1. 213(d)(1) medical care means amounts paid
a. for diagnosis, cure, mitigation, treatment, or prevention of
disease, or for the purpose of affecting any structure or function
of the body
i. This is where the bulk of litigation happens
b. for transportation primarily for and essential to medical care
c. for qualified long-term care service (nursing home)
d. for insurance covering medical service or long-term medical
2. 213(b) Only prescription drugs and insulin are deductible
a. Over-the-counter drugs are not covered
vii. Cases
1. Taylor v. Commish Doctors orders were not to mow lawn due to
allergies, so hired a gardener
a. NOT deductible
i. There was no showing that family member couldnt do it
ii. Also, no proof that he wouldve mowed the lawn had he
had no allergies
2. Hendersn v. Commish had to make van modifications for sons
wheelchair; wanted to deprecate the value of the van
a. Depreciation NOT deductible; only expenses paid are
b. Modifications of van was deductible in year they were paid
3. Ochs v. Commissioner - Doctor ordered for kids to go away while mother
dying from cancer; wanted to deduct cost of boarding school
a. NOT Deductible
b. The court said the expenses were needed due to loss of wifes
services, but if she had died they definitely wouldnt be
c. DISSENT: mitigation, treatment or prevention of desease is
allowed for a deduction. If wife had been sent to nursing home,
it wouldve been deductible
i. The suggested test is: Would taxpayer normally spend
money in this way regardless of the illness
d. The issue may be of causation
i. Did the illness cause them to send the kids to boarding
1. Was the boarding school needed because of the
kids or because of the illness?
viii. Notes on Medical Expenses
1. Transportation costs for medical care - Deductible
2. Costs of birth control, legal abortions, and vasectomies - Deductible
3. Costs of psychiatric treatment - Deductible
a. But marriage counseling is not
4. Costs of fitness training and weight reduction are NOT deductible
a. Unless obese, because its recognized clinically as a disease
5. Trip on doctors orders, NOT deductible
6. Hotel costs for a person who was removed from hospital due ot
overcrowding Deductible
7. Impatient addiction treatment - Deductible
8. Cost of long term care for chronically ill including costs of
maintenance services Deductible
9. Cosmetic drugs NOT Deductible
10. Cost of Medical Insurance Deductible
11. Extra costs, and only the extra costs, of aids for the handicapped such as
car modifications are deductible
a. Braille book costs $15, regular book cost $5; deduct $10
12. If you make improvements to your home recommended by doctor
Deduct the amount the expense exceeds the additional value to your
13. Cosmetic Surgery NOT Deductible
a. Repair for defects of cosmetic surgery Deductible

d. Charitable Contributions
i. 170(a)(1) allows taxpayer to claim as an itemized deduction any charitable
contribution . . . payment of which is made within the taxable year.
ii. 170(c) A charitable contribution is defined as a contribution or gift to certain
enumerated eligible donees:
1. States, possessions, or political subdivisions of the US if the contribution
is made for exclusively public purposes
a. Like donations to public libraries, parks, etc.
2. Organizations that are organized and operated exclusively for religious,
charitable, scientific, literary or educational purposes or to foster national
or international amateur sports competition or for the prevention of
cruelty to children or animals
3. A post or organization of war veterans
4. Individual gifts to domestic fraternal society, but ONLY IF such
contribution is used exclusively for religious, charitable, etc. purposes
a. So have to give to the Rotary Charity Fund, not Rotary itself
5. Certain non-profit cemetery companies
iii. Eligible donees continued
1. Need to non-profit
2. Cannot attempt to influence legislation or intervene in political
3. Valid Organizations examples
a. Olympics, Church of Scientology
4. Non-Valid Organizations
a. Governments of foreign countries, individuals, Political
i. Political Organizations can have entities that are tax
deductible like education and litigation funds
iv. Limitations
1. Individuals can only deduct up to 50% of AGI
2. Corporations can only deduct up to 10% of AGI
3. If anything above the ceilings, you carry that forward for 5 years
v. Notes on Charitable Donations
1. Any non-reimbursable expense in connection with the charity is
a. i.e. Transportation costs to go work at a charitable event
2. Penalties for getting the value wrong
a. Have to pay the tax burden difference plus interest and maybe a
penalty below
b. Accuracy-related penalty if deficiency is at least $5000 and
i. If claim that value of property is two or more times the
actual value of the property.
1. Penalty of 20% the tax defiency that results from
ii. If claim is 4X actual value
1. Penalty is 40% of deficiency
vi. Donations of Property
1. If a person donates appreciated long-term capital property (stocks,
valuable items) to a charitable institution, the taxpayer generally can
deduct the FMV of the property, not just the basis
2. Independent appraisals are required for gifts of property with value
greater than $500
3. Tangible Property
a. If gift is related to the purpose of charity receiving it FMV
b. Gift that would produce ordinary income, such as inventory
Basis deduction
4. Examples
a. Non-tangible Property stock
i. Basis $1000; FMV $5000; can deduct $5000
b. Tangible Property paining
i. Basis $1000; FMV $5000
1. If charity sells it - $1000
2. If charity USES it - $5000
5. Planning: You can probably always deduct at FMV more than you can
sell it for
vii. Private Foundations
1. 509 Trusts or corporations organized for charitable giving that
receives its principal support for one person or family
a. ex: Ford Foundation, Carnegie Foundation
2. They are criticized for maintaining the power of donors ideology
through grants and other self-serving behavior
a. But are subject to special regulations to ensure that they spend a
portion of them on charitable assets
viii. Private Benefit
1. Ottawa Silica Co. v. United States
a. Ottawa was a mining company that donated land for HS
i. Did it because a road would have to be built for HS and
they would directly benefit Ottowa because they intended
to use some of that land for housing development
b. Court says: Ottowa does not get a charitable deduction because
the company received a substantial benefit from the building of
the school access roads
c. Why didnt Ottawa just call it a business expense and deduct it?
i. They would have to capitalize it because giving this land
away increased the value of the rest of the land, so can
only writ it off when they sell the land
2. Examples of what and how much can be deducted
a. Donate $100 and receive 2 CDs
i. Part deduction - $100 FMV of CDs
b. Give $1M to Law School; In return you get a $5000 lunch in
your honor
i. Whole $1M
c. Donates $10K in return for right to purchase 2 season tickets for
$500 each
i. Even if you get tickets in return, you get to deduct 80% of
the cost
d. Make payment of $1000/year to rent pew at church
i. Fully Deductible - Special Rule Pew fees are not
considered substantial benefit
e. Donates $100K to LA Philharmonic and get a bunch of benefits,
like dinners and publish of names
i. Under tax code, Philharmonic has to report FMV of
package to IRS
ii. Deduct 100K FMV of package
ix. Discriminatory Charities Bob Jones v. US
1. BJU believed interracial marriage and dating is immoral
2. Contributions NOT deductible because the commitment to racial equality
is a fundamental societal goal and charitable donations should not be
permitted to institutions than undermine that goal
a. Non deduction is limited to racial discrimination
x. Is the Charitable Deduction a Good Idea?
1. Yes
a. The deduction encourages donations to charity
b. The deduction promotes desirable social spending without the
interference of government
c. The deduction is needed for an appropriate measure of ability to
pay because donor cannot spend the money she has given away
d. The deduction places donors of money and donors of services on
an equal footing
2. No
a. The deduction often supports activities that a democratically
elected government would never fund directly
b. Activities enjoyed by the rich such as the opera and museum
often receive larger donations than organization to help the needy
c. The deduction is an upside down subsidy. A $100 contribution
reduces the tax burden of a top bracket taxpayer by at least $40
but doesnt reduce the tax burden of a non-itemizer at all
d. Gifts of property are plagued by fraudulent valuations
e. Donors really get benefits: prestige, invitations to meet stars, etc.
f. Fund raising is very expensive. Taxation is a much cheaper way
to raise money for public purposes
g. The deduction constitutes an indirect support of religion
e. Interest
i. 163 Business or investment interest generally is deductible
ii. Interest on personal loans generally is NOT deductible 163(h)
iii. Qualified residence interest is deductible 163(h)
iv. Two categories of qualified residence interest
1. Acquisition indebtedness
a. Debt thats:
i. Incurred to buy, build, or improve a qualified residence
ii. Secured by the residence
b. $1M limit on it can deduct the interest on up to $1M
i. So if you borrow $2M, you can deduct interest on $1M of
2. Home equity indebtedness
a. Debt that is secured by a qualified residence and is NOT
acquisition indebtedness
b. Its limited to the lesser of
i. $100,000 or
ii. The FMV of the home, less the taxpayers acquisition
v. Examples
1. Buys home for $2M; Mortgage of $1.5M
a. Use acquisition indebtedness for $1M
b. Use home equity indebtedness for $100K
c. Remaining $400K is taxable
2. Buys $500K home; $300K mortgage. One month later $150K mortgage
a. Use acquisition indebtedness for $300K mortgage
b. Home equity for $100K
c. But remaining $50K is not deductible
3. Moral of the story is For tax purposes, better to buy a home than to
vi. Qualified Residence: the taxpayers principal residence and one other residence
1. A dwelling that the taxpayer rents to other can be a qualified residence if,
during the year, the taxpayer uses the dwelling for the greater of
a. 10 days or
b. 10% of the number of days that it is rented
2. Interest payments would be allocated between the rental and personal use
vii. Refinancing of Acquisition Indebtedness
1. If acquisition indebtedness is refinanced, the new debt also is acquisition
indebtedness up to the amount refinanced
2. Ex: Home with FMV of $400K with AI mortgage of $150K; refinance
$300K; $150K of the new mortgage is AI
a. Other debt is: $100K of home equity; $50K, not deductible
viii. Taxation of Points
1. Points must be capitalized and deducted over the life of the term of the
2. Exception: Points paid on debt secured by principal residence AND
incurred to purchase or improve the residence may be deducted in the
year paid
3. Planning should you get high points or high interest?
a. Better to take points on original loan then taking it on refi
b. On original loan can deduct
i. But refi you need to capitalize it
4. Non-tax planning
a. If your going to hold loan for long time Get points
i. Interest rate will be lower
ix. Policy Is it good?
1. Yes
a. Encourages home ownership
b. Prevents large losses for people who relied on the pre-1987
interest deductions
2. No
a. For the Rich
b. Why not have interest free loans for everything
c. Can deduct interest secured by homes (home equity
indebtedness) and buy something unrelated to home
d. Encourage individuals to overinvest in housing

x. Student Loans
1. 221 permits a deduction of the interest on qualified education loans
2. Qualifying education expenses include tuition, books, fees, supplies, and
equipment for students enrolled on at least a time basis
3. Deduction may be taken even if taxpayer does NOT itemize
4. Max deduction is $2,500
5. Deduction is available only for the first 60 months in which payment of
interest is required
6. Deduction is phased out for single taxpayers with income above $50K
and joint above $100K

f. State and Local Taxes

i. Business and investment taxes
1. All taxes, other than with a trade or business or with an investment are
2. Except: Taxes associated with buying property its capitalized into the
price of property
ii. Individuals can deduct
1. State and local property taxes
2. State and local personal property tax
a. So a car tax is deductible
3. State and local income taxes OR state and local sales tax, whichever is
a. Theres a chart in the Tax Booklet that lets you estimate what
your sales tax would be with your income
b. Griffith wants to eliminate the sales tax, raise the income tax and
would make this deduction bigger
4. NOT Deductible: State and local user fees such as sewer fees, tuition at
state colleges and park fees are not deductible
iii. Policy Should we allow deductions of State taxes?
1. We want deductions to adjust to meet ability to pay
2. So how should this be characterized?
a. Payments for government services received by each taxpayer
where the services are received are roughly equal to the amount
of taxes paid NO Deduction
b. Compulsory payments that reduce a taxpayers ability to pay and
which have little relationship to the level of government services
received - Deduction
3. Answers
a. Its true people in higher tax states get better government services
b. And the people who pay more tax dont necessarily get better
c. So its debatable

g. Dependency Exemptions
i. $3100 for year 2004 Adjusted annually for inflation
ii. Dependent must
1. be related by blood, marriage, or adoption
2. get more than of support
3. have gross income less than exemption (does not apply if there
dependent is taxpayers child, is either under 19 or a student under 24
and, if married, does not file a joint return with his spouse)
iii. Only one parent gets exemption for one dependent

h. Earned Income Tax Credit (EITC)

i. In 2002, EITC generated $26 Billion in payments to poor families, which is a lot
more than welfare
ii. Credit is a % of earned income
iii. Having up to 2 kids increases the size of the credit
iv. Credit is refundable individuals may receive cash payments from government
if credit exceeds liability
1. You get paid if exception exceeds tax liability
v. Can be viewed as a wage subsidy for very low income workers
1. Increases incentive to work
vi. At higher levels of income the credit is phased out
1. Within the phaseout range, the credit discourages additional work effort
because it acts like an additional tax, reducing the after-tax income form
2. If you earn another $1000/year, it may kick you out of your EITC
benefits and the tax burden for that new money may be 100%
3. Poor has high marginal rates of total taxes because poor people pay flat
taxes of SS and Medicare, and because of these phaseouts
vii. Significant marriage penalty
1. The penalty is extraordinary high if two single parents marry
2. For two single parents with 2 kids each, marriage reduce their EITC over
$6000, which is about 25%
viii. EITC is highly subject to fraud and taxpayer error.
1. Thus, IRS frequently audits taxpayers who claim the EITC
2. And the penalty is more Draconian because they make them unqualified
for it even when they qualify for a few years
ix. Also some who qualify dont take it because the rules are very complicated and
they sometimes dont know
x. Summary:
1. Good because it encourages people to work
2. The phaseouts have a lot of disincentive effects

i. Miscellaneous Credits
i. Adoption Expenses
1. Up to $10K/child
2. Phased out to incomes over $150K
ii. Child Tax Credit
1. $1,000/child for 2004
2. Phased out for taxpayers with incomes of $110K (joint) or $75K (single)
j. Phaseouts
i. Are in personal exemptions, child tax credits, adoption expenses, student loan
expenses, EITC
ii. Biggest impact is the EITC phase out explained above
iii. Affect upper-middle class too ($75K - $400K) who are subject to many of them
iv. Policy: Whats wrong with them
1. Make returns incredibly complicated
2. Would probably be better to just raise the marginal tax rate 1% and
eliminate the deductions and credits anyway

VI. Mixed Personal and Business Expenses

a. Introduction
i. 162 permits a deduction for ordinary and necessary expenses paid or
incurred . . . in carrying on any trade or business
1. Ex: Lawyer can deduct bar dues and cost of legal periodicals
ii. 212 permits deductions associated with generating income sources as other
than a trade or business
1. Ex: Tax Prof can deduct cost of WSJ or Economist
iii. 67 limitation on employees 2% AGI Floor
1. Employers and self-employed are not subject to 2% floor

b. Hobby losses
i. 183 For activities not engaged in for profit, there shall be allowed
1. The deductions which would be allowable whether or not activity for
profit (i.e. personal deductions) AND
2. The deductions permitted if the activity were engaged in for profit, but
only to the extent that the gross income from the activities exceeds the
deductions allowable under #1
a. These are subject to 2% floor
ii. How you figure it out
1. Start out with income from activity
2. Subtract deduction you can take such as personal deductions
3. Remaining is net profit
4. You can deduct the costs associated with the activity subject to the 2%
iii. Why being a professional is better
1. Hobby only deduct losses to the extent that theres winnings and
subject to a 2% floor
2. Professional if losses, can deduct even if there was no winnings and
no floor
iv. 183(d) presumption
1. If activity has made a profit in 3 of past 5 years (or 2 of 7 if horse
breeding) it is presumed to be an activity engaged in for profit
2. Taxpayer can elect to wait for 5th year to determine if presumption is met,
but must waive the statute of limitations if he does so
v. Nine Factors to determine if its a profession or hobby
1. Whether the taxpayer carries on the business in businesslike manner and
keeps complete and accurate books and records
2. Degree taxpayer prepared for the activity either by study or consultation
with experts
3. Time and effort expended in carrying on a business
4. Likelihood that assets used in activity will grow in value
5. Success or failure of taxpayer in carrying on similar activities
6. History of income and losses with respect to activity
a. But start-up losses do not demonstrate lack of profit motive
7. Profits earned as compared with the taxpayers investment in and losses
from activity
8. Financial status of taxpayer
9. The degree the activity appears to be recreational or for personal
a. The more fun the activity is, the more likely to be a hobby
vi. Collecting items such as art, stamps is generally considered a hobby
vii. Game show contestant Whitten v. Commish
1. Tried to deduct cost of attending Wheel of Fortune, including meals
transportation as wagering losses after wining $20K
2. Court held amateur gambles can only deduct amounts lost on bets, and
cannot deduct meals, transportation, etc.
c. Home Office
i. Rules are complex but generally:
1. Deduction permitted if office is EXCLUSIVELY used on a regular basis
as a principal place of business
2. Deduction generally not permitted for employees, because it has to be
your principal place of business
a. Employees principal place of business is work
3. In Popov, the 9th circuit permitted a deduction of a portion of the living
room of a one bedroom apartment of a professional violinist who had no
other practice facility
a. Even though it probably wasnt used exclusively for practicing
it seems like it was a fair sense of justice in this case

d. Alternative Minimum Tax

i. Important vocabulary
1. Above the line before the calculation of AGI
2. Below the Line itemized deductions, miscellaneous deductions
a. These are worse because
i. Can only take them if you itemize
ii. For AMT, you lose some of them
ii. Aggregate Gross Income (AGI) is used to determine floors for your deductions
iii. Personal Exemptions get phased out with higher AGI
iv. Expenses from Business is the most important above the line
v. Two deductions you cant take in AMT
1. Deductions for state and local taxes
2. Personal exemption
vi. Whos being hit bye AMT?
1. People with a lot of kids and
2. Live in a state with high taxes
a. CA has double the share of AMT
vii. Why its becoming more and more an issue
1. Have not been adjusting AMT for inflation, and tax rate has so its
affecting a lot more people now than it has in the past
viii. AMT hits upper middle class people because their regular tax rates arent high
1. But rich people (over $1M) regular tax rate is so high that AMT probably
wont hit them

e. Happiness Article
i. Easy utilitarian case for progressive taxation
1. Income has declining marginal utility so redistribution from rich to poor
increases total utility
2. The higher marginal tax rates required for redistribution produce an
efficiency or deadweight loss, primarily by reducing work effort
3. The welfare gains from redistribution must be weighed against the
efficiency costs of higher tax rates, but under plausible assumptions,
some level of redistribution is desirable
ii. Optimal level of redistribution requires estimating both the efficiency costs of
higher tax rates and welfare gains from redistribution
iii. Utility function is based on logarithm of income
1. Survey rather have $100K for sure than 50/50 of $50 or $200K
2. Suggest that people really care more about the first money than the new
iv. Happiness Surveys
1. Ask questions like on scale of 1 to 10 how happy are you
2. Problems with them
a. Misremembering pleasure and pain
b. Exaggerated impact of current moods
i. When its sunny, better answers
ii. When lab stinks, worse answers
c. Peoples last memory is really what they report of their happiness
3. Though the tests are noisy we are looking at happiness of groups, so
all the nose gets balanced out over time
4. These experiments do correlate with:
a. Reports of family and friends
b. Smiling during interviews
c. Attendance at work
d. Ability to recall positive events in life
e. Low Suicide rate
5. Conclusion: While not without problems, these subjective measures may
provide useful information about the causes and correlates of human
v. Cross-National Comparisons
1. Wealthier Nations show much greater happiness than poor nations
2. Among poor nations, additional income has significant impact on
a. Extra $1000 raises happiness by 1/10 a standard deviation
3. Among rich nations, additional income has a very small impact on
a. Extra $1000 raises happiness by 1/50 a standard deviation
4. Other factors
a. Former Soviet bloc nations are less happy then predicted by
b. Protestant nations are happier then predicted by income
c. Democracy, political stability and political liberty are correlated
with happiness, but these factors are so closely correlated with
income that it is difficult to determine their independent influence
on well-being.
5. In sum: Cross national comparisons are consistent with the traditional
notion of declining marginal utility of income additional income
increases the utility of the citizens of all nations, but has the greatest
effect where those citizens are poor
vi. Longitudinal Studies of National Well-Being
1. High rates of economic growth may only have a modest impact on the
long-term happiness of the citizens of developed nations
2. Long-term economic growth has a surprisingly small impact on well
being of nations
a. In US Real Income from 1972 to 1998 grew 58%, while no
increase in very happy
3. Rapid growth in France and Japan since WWII has produced little
increase in happiness in those countries
4. Little correlation between rate of economic growth and growth in
5. In Sum
a. Additional income has much greater impact on poor nations than
on rich
b. Long-term economic growth has a surprisingly small impact on
the well-being of nations once a reasonable level of economic
development has been obtained
vii. Happiness and the US Income Distribution
1. From poverty to middle-class
a. Moving from bottom decile to fifth decile in 1996 required an
additional $12,177 of income and produced a utility gain of 0.25
b. In this low income range, and additional $1,000 produced an
average increase in happiness of .0205 points
2. From middle-class to upper-class
a. Moving from the sixth decile to top decile in 1996 requied an
additional $44,170 and produced a utility gain of .07 points
b. In the high income range, an additional $1000 produced an
average increase in happiness of only .0016 points
3. Declining marginal utility of income
a. An extra $ of income over the high income range had less than
8% of the impact on happiness of an extra $ in low range
4. Dissatisfied Rich
a. Households in the top decile have seen a much greater than
average growth in income 33.4% as compared to an average
increase of 8.5% for the lower nine deciles
i. Yet these households reported no increase whatsoever in
viii. Happiness Paradox and Relativity Trap
1. Growth in Incentive over time has little impact on happiness
a. Substantial economic growth over the past several decades did
little to raise the happiness levels in developed nations
b. Although individuals with higher incomes are, on average,
happier than poorer individuals at any point in time, the average
happiness of a cohort remains relatively constant over their
lifetimes despite significant growth in income
2. Happiness Paradox
a. At any given time, people with more money tended to have
greater satisfaction with life than those with less, but increasing
the income of all people does not increase reported happiness
3. Relative Income and happiness
a. Happiness may depend more on an individuals relative income
than on the individuals absolute income
b. But leisure is less positional than income
4. Policy: Positional Goods and policy
a. The standard argument that taxation produces inefficiency by
reducing work effort may be only half true
i. Taxation will reduce work effort, but that reduction may
be efficient
b. The reason is: Earning additional income imposes a much larger
negative externality on other than does enjoying additional
leisure. To the extent that earning additional income produces a
negative externality, it may be efficient to tax that income
ix. Beyond Rivalry Adaptation & Aspiration
1. Misjudging the Value of Money
a. When individuals are asked what change would most improve the
quality of their lives, the most frequent response is more
b. The actual increase in happiness is modest
c. A study from Illinois lottery winners found that their happiness
was not significantly different from controls
i. Lottery winners reported significantly less pleasure than
nonlottery winners from ordinary experiences such as
talking to friends, eating breakfast, and laughing
2. Explaining the small increase in happiness
a. Adaptation Theory
i. More material goods provide additional pleasure at first,
but the impact is largely temporary
b. Aspiration Theory
i. Individuals aspiration levels rise as their income rise
ii. One study found that this preference shift destroys 60-
80% of welfare effect of an increase in income
x. Improving Long-term happiness
1. Positional goods
a. Income spent on such goods does nothing to improve welfare of
2. Non-postitional (relatively) correlates to happiness
a. Leisure activities, especially involving social interaction
b. Volunteer work
c. Stronger family/love relationships
d. Exercise and Good health
3. Why is the Misery Index Unemployment and Inflation if that has
nothing to do with happiness
4. Other potential nonpositional items are clean air, public safety, parks
xi. Happiness and Inequality
1. Inequality itself has a significant impact on happiness in Europe, but
little impact in the United States
a. In US, Rich leftists are the only ones who would like equality
i. Poor leftists and all righties dont care about equality
2. 70% of US feel that people are poor because of laziness; 70% of West
Germans feel its because of society
xii. Race and Redistribution
1. Black poverty rate is 3 times higher than White
2. Most Whites think Blacks would be as wealthy if they tried hard enough
3. Support for welfare in the US is higher among people who live near
welfare recipients of the same race, but lower among people who live
near welfare recipients of different races
4. More ethnically fragmented states spend a smaller portion of their budget
on social services
5. Policy: Why it may not be desirable to give weight to racial bias
a. Fairness considerations to disadvantaged groups
b. Policies based on stereotypes of Blacks may not be in long-run
self-interest of Whites
i. Spill-over effects of poverty such as high crime rate
ii. Also, people in favor if segregation in 1960s are now
saying they regret their former attitudes and are happier
with the current racial climate
xiii. Tax Policy and Happiness: Summary
1. The traditional notion of declining marginal utility throughout the
income distribution is still sound. However, the traditional shape of the
marginal utility curve may need some adjustment
2. The impact of additional income on different groups may be a difference
in kin rather than simply one of degree.
a. For poor individuals, where income is purchasing goods that
satisfy basic needs, most of the goods purchased will be
3. Purchases by the poor
a. Are likely to have a relatively low negative externality from
rivalry and may actually have a positive externality to the extent
that individuals have a distaste for inequality
b. Are likely to show little decline in value from adaptation
4. Revenue from increasing taxes on the rich to support a middle class tax
is likely to produce a far smaller improvement in well being than would
using that same revenue to fund basic services for the poor
5. Direct government expenditures on non-positional goods may increase
well-being more than reducing taxes, because private individuals are
likely to sue much of the additional income to purchase positional goods

f. Office Decoration
i. Have to show a good business purpose for purchase of decoration in order to
deduct it
ii. Hypos
1. Employee Buys painting and rug for office Henderson v. Commish
a. NOT Deductible no good business purpose
2. Self employed, buy a paining and rug for office
a. Deductible thinks its good for business defer to owner
3. Law firm buys decorations for lawyers office
a. Employer not taxed, its a business expense
b. Employee not taxed, working condition fringe
4. Law Prof buys painting and rug for office and donates it to the school
a. NO charitable deduction because receives substantial benefit
from it
iii. IRS defers to business to determine if its a business expense
1. If employee buys, theres a heavier burden of proof

g. Travel and Entertainment

i. The key is the dominant purpose of the trip
1. If its to reward employees taxable,
2. if it actually has business purposes, tax-free
ii. Trading in your ticket
1. If you trade your ticket in for cash, even if it was a business trip taxed
on the cash
2. If you trade your ticket for anything non-business related, like a ticket
for your wife youre taxed on it
iii. 162(a)(2) allows taxpayer to deduct travel expenses, including costs of meals
and lodging if:
1. The travel expenses are reasonable and appropriate
2. The expenses are incurred away from home (overnight) and
3. The expenses are motivated by business rather than personal reasons
iv. 274 Meals and entertainment expenses (not away from home)
1. Deduction is permitted for activity generally regarded as entertainment
or recreation(including meals) only if the activity is directly related to
the active conduct of a business.
a. Entertainment expenses solely designed to develop goodwill are
not deductible
b. Directly related like a chef checking out other restaurants,
scouts going to a baseball game.
2. Exception to #1 Deduction is permitted if the entertainment or meal
includes or directly precedes or follows a substantial and bonafide
business discussion and if the entertainment or meal is associated with
a. If theres anything where theres a business discussion
b. Very easy to meet
3. Deductions for meal and entertainment expenses generally are limited to
50% of the costs. Exceptions include food provided as a de minimis
fringe and meals provided on oilrigs
a. If a Firm buys Dodger season tickets can deduct 50%
b. When associate gets 1 or 2 tickets a year not taxed as de
minimis fringe
4. Deductions for tickets are limited to face value of tickets (except for
certain charity events)
5. Dues for social clubs are not deductible
a. Cant deduct membership to country club and airline clubs
6. Deductions are not permitted for conventions on cruise ships or outside
the United States (if its not reasonable to have it there)
7. No Deduction for travel as a form of education
v. Combination of Business and Personal Travel
1. Within the United States
a. If primary purpose of travel is business, the entire trip is
deductible except the extra cost of personal stuff
i. Ex: Have to be in NYC for a deposition on Friday, so
after spend you spend weekend there
1. Plane fare, Friday night stay is deductible
2. Saturday night and show tickets are taxed
2. Outside of Untied States
a. If less than a week or less than 25% of time is spent on personal
i. Taxed like within the United States, above
b. If more than 1 week and if 25% or more of time is spent on
personal activities then ALL costs must be allocated between
personal and business.
i. Can only deduct 1/3 of airfare to Paris if its a 4 week trip
where 2/3 of time is persona.
vi. Spouses/friends on business trips
1. Expenses not deductible UNLESS:
a. The person accompanying is an employee of taxpayer or is the
taxpayers employer
b. The person is coming along for a business purpose AND
c. The travel expenses of the person are otherwise deductible
vii. Substantiation requirmetns
1. Expenses must be proven
2. Common methods are receipts or a contemporaneous log.
3. Some exceptions to it include small expenditures and per diem and
mileage allowances paid by employers to employees, up to certain
a. Per Diems big here
viii. Dont forget Employee Business expenses are subject to the 2% floor
ix. Business Lunches
1. Moss v. Commish
a. Lawyers in firm met daily at restaurant near offices and discussed
i. If paid for by firm, TAXED because not on business
ii. Not Deductible under 162 because not a good business
purpose for these lunches
1. Could discuss at any time
b. Should these be deductible?
i. Yes business reason is that it saves time
ii. No everyones gotta eat lunch anyway, there could be a
lot of abuse
2. Hypos
a. Lawyer takes client to lunch to discuss case
i. Deductible subject to 50%
b. Client takes lawyer to discuss
i. Client can deduct if its a business case
ii. If its personal (divorce, etc.), they cant deduct
c. Lawyer takes him for good will
i. Taxed, would need a bonified business discussion
d. Partner takes associate to lunch to talk about future?
i. Deductable good reason to have it in restaurant and not
e. Partner takes associate to lunch to tlak about a pending case?
i. Closer case, because could be abused
f. Two partners go to lunch each week to talk about ongoing cases?
i. Probably not deductible
g. Weekly lunch meeting with everyone talking about firm stuff at
the firm?
i. Deductible
h. Ordering food in with clients?
i. Deductible
3. Lunches with clients and Summer Associate Lunches most likely
always deductible
x. Ordinary and Necessary Expense Requirement
1. To be deductible under 162 expense is:
a. Common and accepted in relevant business community AND
b. Appropriate for the development of business
2. Danville Plywood Corp. v. US
a. Danville provided free trip to Super Bowl to customer reps and
i. There was no business meetings, but there were product
b. Not deductible because no actual business was being conducted
i. Couldve made some of it deductible by having plywood
everywhere, and business decisions
1. But then could only deduct for the employees, and
not for kids and spouses

h. Policy: Efficiency of mixed deductions

i. It is inefficient to deny deductions for a purely business expense. If a genuine
business expense is not deductible, a business may not incur the expense even if
the incurring the expense would be profitable on a pre-tax basis
ii. If a purely personal expenditure is deductible to the employer and not included
in the income of employee, the employer will be encouraged to make the
expenditure even if, on a pre-tax basis, the employee would prefer cash.
iii. Mixed personal and business expenses are efficient if the total value ot employer
and employee exceeds total cost. Taxing the employee on the subjective value
of the expense always will achieve the efficient result, but it is impossible for the
IRS to determine the subjective value
iv. If the employee is taxed less than subjective value, an inefficient expenditure
may be made
v. If employee is taxed more than subjective value, an efficient expenditure may be

i. Child Care Expenses

i. Cannot deduct cost of maid to take care of the kids to enable wife to work
Smith v. Commish
1. Rejected because it would allow for deduction of food, housing, and
other necessities of life you need to work
ii. Policy Two perspectives
1. Child care is cost of working But for the job you would not incur child
care expense
2. Child care cost of having children But for the children you wouldnt
have to get child care
iii. Policy Analysis
1. Compare 2 worlds
a. World 1: Deduction permitted for child-care
b. World 2: No deduction permitted for child-care
2. Consequences of deduction would be
a. More individuals with children enter work force. Fewer small
children have parents as full-time caretakers
b. More individuals have children
c. Working individuals with children are wealthier
d. Families who do not pay for child care in order to work are
poorer because their taxes must be raised to pay for the deduction
for others
e. Families purchase more and more expensive child care
i. Fewer children are left with unpaid caretakers such as
relatives and friends
ii. Demand for and wages of child care workers increase
3. Discuss if you want the consequences
iv. 21 Child Care Credit This is a new law
1. Limited tax credit is permitted for qualifying expenses
a. 35% of expenses for taxpayers of AGIs less than $15K
b. 20% of expenses for taxpayers of AGIs higher than $43K
c. Sliding scale between the 2 if AGI is between 15 and 43
2. Care must be for qualifying individual
a. Dependent under 13
b. Spouse or dependent incapable of taking care of himself
i. But only if living in household
3. Care can include
a. Expenses for household service including cleaning
b. Expenses for care of qualified individual
i. Cant be overnight camp
ii. Can be day care or day camp
4. Creditable amount is limited to $3,000 for 1 qualifying individual and
$6,000 for 2 or more
a. So, AGI of $50K with 2 kids, the most credit they can take is
$1,200 (20% of $6,000)
5. Expenses are creditable only if employment related
6. Creditable expenses are limited to earned income of lower earner
a. Designed for childcare associated with working
b. The creditable amount can never be more than the lowest earner
of the couple
v. 129 Child Care Exclusion
1. Max of $5,000/year of dependent care may be excluded through an
employer provided dependent care assistance program.
2. Any amount excluded reduces the creditable expenses that may be taken
into account under 21
vi. Planning: Take 21 Credit or 129 Exclusion?
1. 129 may be better than 21 credit if taxpayers marginal tax rate is
higher than the credit rate
2. Ex: you have $10K in expenses for 3 kids in 30% bracket
a. Take credit: Get credit of $1,200
b. Take Exclusion reduce income by $5,000 so tax burden will
be lowered by $1500
i. But can also get the credit, reduced by the exclusion so
can only take a credit on the $1000, which would add a
reduction of $200 to tax burden

j. Commuting
i. Cannot deduct commuting expenses
ii. Revenue ruling 94-17
1. Traveling to and from work generally is a non-deductible commuting
a. If your company gives you a car, taxed on it if used to get to and
from work
2. Going from one business location to another is deductible
3. If taxpayer works at various different jobs then travel to each is non-
a. Maid travel costs from different houses are non deductible
b. Maid with a maid service first drive to HQ (thats not
deductible) but after HQ to homes, thats deductible
i. Even if you dont go to HQ first, its deductible
4. However, travel to a temporary job outside taxpayers metro area is
5. If a taxpayer has a regular job, travel to a temporary job within the
metropolitan area is deductible
6. If taxpayers residence is the taxpayers principle place of business, then
the taxpayer may deduct transportation expenses between residence and
other work locations in the same trade or business.

k. Clothing
i. Three requirements to deduct work clothing Pevner v. Commish
1. The type of clothing must be required as a condition of employment
2. The clothing must NOT be adaptable to general usage as ordinary
3. The clothing must NOT be worn outside of work
ii. Uniforms are always deductible
iii. Should Pevners clothes be deductible fancy clothes she wouldnt have bought
by her self; she doesnt wear them outside work
1. Yes
a. She has less real income than an employee who is required to
purchase expensive clothing.
b. She should get it for excess of YSL for ordinary clothing
2. No
a. It is hard determining who would use the clothes outside work
iv. Hypos
1. Can tennis pro deduct tennis clothing?
a. NO, its too popular; can wear it in ordinary life
2. Fire, police, military
a. Deductible
3. Custom suits like Century 21 blazers
a. Deductible cant really wear them out
4. Mr. Rogers and his sweaters
a. Close case could wear them out, but probably wouldnt

l. Expenses of Education
i. Education expenses are deductible only if the education:
1. Maintains skills or is required by an employer; AND
2. Does not provide training towards a new occupation
ii. Carroll v. Commissioner Philosophy education and police officers job is not
closely enough related to qualify for deduction
iii. Notes on Education
1. On the job training is deductible by employer and tax-free to employee
2. Expenses of acquiring an LLM in taxation are deductible for a practicing
attorney, but not for a student who attends directly after law school

m. Current Expenses vs. Capital Expenditures

i. If a business expenditure creates an asset with a useful life exceeding one year,
then an accurate measurement of income requires that the expenses be
ii. Example Buys machine for $100K that will generate $20K in revenue for 10
years, then be worthless. How much did Maria make last year?
1. 80,000 loss? No, she still has the machine
2. 20,000 gain? No, machine has lost some value
3. 20,000 gain minus depreciation of machine? Yes

iii. Repair and Maintenance Expenses

1. Repair: Returns property to a sound state. Does not add to the value of
the property or prolong its useful life
a. If window is broken and fixed its a repair, can deduct entire
cost immediately
2. Capital Improvement: Prolongs the life of property, increases its value or
makes it adaptable to a different use
a. Add room to business needs to be capitalized over useful life of
3. Midlands Empire Packing Co. v. Commish
a. He Cured ham in basement that leaked water for 25 years. The
water became contaminated with oil from nearby refinery.
Federal meat inspectors required the elimination of contaminated
water, so he waterproofed the basement
b. Court held: waterproofing is more like a repair because it restores
basement to prior operating condition
4. Revenuer Ruling 94-38
a. Cost to treat land and groundwater for hazardous waste caused by
taxpayer deductible under 162 or must it be capitalized under
b. Cost of groundwater treatment facilities must be capitalized
i. But cost of annual treatment expense can be deducted
immediately because it returns land to original condition
5. Its all or nothing its either a repair or cap improvement never a little
of both
6. The difference is often difficult to determine
7. Capital improvements were found for:
a. Installation of sprinkler to meet fire code
b. Drainage system for newly constructed drive-in theatre
c. Replacement of asbestos with a less effective but safe insulation
8. Special rules for cleaning up poor neighborhoods they are immediately

VII. Ordinary and Necessary Expenses

a. Gilliam Case
i. Gilliam is an artist on business trip he goes crazy and attacks a passenger
1. Settles a tort claim
ii. Can he deduct cost of criminal defense and tort settlement as business expense?
1. NO theye not ordinary expenses of trade or business
b. Ordinary expenses are those that frequently occur in the type of business the taxpayer is
engaged in.
i. If youre a professional criminal, can deduct lawyer fees, but you would have to
declare that youre a criminal
c. If Gilliam had paid someone to make sure he doesnt go nuts, thatd be deductible
d. As long as there is an hones belief that its an ordinary and business expense its
i. If you think yoga will help your employees, you can deduct it
e. Its the motivation, not the smartness of the decision that is relevant.