WHAT IS INCOME?

RECEIPT OF ECONOMIC BENEFITS: SECTION 61

Cesarini v. United States

Rule of Law: All income is subject to tax unless an express exemption applies.

Facts: The Cesarinis (plaintiffs) purchased a used piano at an auction in 1957. In 1964, they
discovered $4,467.00 in cash hidden inside the piano. They reported the sum as income in their
1964 income tax return. In 1965, they filed an amended income tax return, in which they
removed the sum of $4,467.00 and requested a refund of the $836.51 in taxes they paid for the
found money. The Commissioner of Internal Revenue refused to refund the money and the
Cesarinis filed suit in this court.

Issue: Whether certain income is subject to tax where an express exemption does not apply.

Holding and Reasoning (Young, J.): Yes. The money discovered by the Cesarinis is taxable gross
income because there is no express provision of the Tax Code that exempts it from taxation.
Section 61(a) of the Tax Code defines gross income as all income from whatever source
derived. This court must determine whether this definition includes found money. The United
States Supreme Court has often ruled that the language used in the provision allows Congress to
broadly use its power to tax. Treasury Regulation 1.61-14 further states that treasure trove, or
found money, is gross income, while IRS Revenue Ruling 61-53-1 confirms that found money is
indeed taxable income. Although the Tax Code does exempt certain items from the definition of
gross income, this list does not include found money. Accordingly, this court finds that found
money is gross income for the purposes of taxation. Here, the Cesarinis found $4,467.00 in cash.
Under the broad definition of gross income found in 61(a), the found money is taxable income
unless some express provision of the Tax Code exempts the found money from taxation. The
Cesarinis fail to identify any such exemption. Therefore, this court finds that the money found by
the Cesarinis is subject to taxation and that the Cesarinis are not entitled to a refund of $836.51.
Alternatively, the Cesarinis argue that even if the found money qualifies as taxable income, it
was only taxable in 1957 and that by 1964, the statute of limitations had expired so that the
found money was no longer taxable. However, in Ohio as well as in a majority of other
jurisdictions, income tax is only payable when the income is actually known to the taxpayer.
Although the Cesarinis bought the piano in 1957, they did not discover the money in the piano
until 1964. Therefore, the found money was taxable in 1964 and the Cesarinis properly paid
$836.51 in taxes for the found money.

Old Colony Trust Co. v. Commissioner

Rule of Law: Payment by an employer of an employees income taxes constitutes taxable

gain to the employee.

Facts: William M. Wood (defendant) served as the president of the American Woolen Company
from the years 1918 to 1920. In 1916, the American Woolen Company adopted a resolution to
pay the income taxes of the companys officers. For earnings in 1918, Wood owed $681,169.88
in federal taxes. For earnings in 1919, Wood owed $351,179.27 in federal taxes. In accordance
with its 1916 resolution, the American Woolen Company paid Woods taxes for both years. The
Board of Tax Appeals found that the tax payments made by the company on Woods behalf
constituted additional income.

Issue: Does payment by an employer of an employees income taxes constitute taxable gain to
the employee?

Holding and Reasoning (Taft, C.J.): Yes. Any payment made for services rendered by an
employee constitutes taxable income to the employee. Whether the employer makes the payment
directly to the employee or on behalf of the employee to a third party is inconsequential. Thus,
where an employer makes a payment to a third party to discharge the employees financial
obligations, that payment is still financial gain to the employee, for which the federal
government may impose a tax. Wood entered into his services as president in 1918 and 1919
with the understanding that the company would pay his taxes for those years. The company paid
these taxes in consideration of his services as president of the company, and therefore, the
payments did not constitute a non-taxable gift. Therefore, the companys payment of the taxes is
income for which Woods owes tax.

Commissioner v. Glenshaw Glass Co.

Rule of Law: Punitive damages are taxable as gross income.

Facts: This case concerns punitive damages collected by two companies, Glenshaw Glass Co.
(Glenshaw) and William Goldman Theatres, Inc. (Goldman Theatres) (defendants). Glenshaw
was involved in a suit against a manufacturing company, in which Glenshaw requested
exemplary damages for the defendants alleged fraud and treble damages for injury to
Glenshaws business. In 1947, the parties settled and Glenshaw received $324,529.94 in punitive
damages. Glenshaw did not include the punitive damages in its income tax return for that year.
The Commissioner found that Glenshaw owed tax on the punitive damages. The Tax Court
disagreed, stating that punitive damages were not taxable. Goldman Theatres similarly received
punitive damages when it won an action for federal antitrust violations committed by Loews,
Inc. The trial court found that Goldman Theatres had sustained $125,000 in loss of profits and
awarded $375,000 in treble damages. Goldman Theatre reported $125,000 of the award as gross
income for that year, believing that the punitive two-thirds of the award were not subject to
taxation. The Tax Court agreed. The Court of Appeals for the Third Circuit consolidated the two
cases and affirmed the Tax Courts decisions. The Supreme Court granted certiorari.

Issue: Are punitive damages taxable as gross income?

Holding and Reasoning (Warren, C.J.): Yes. Section 22 of the Internal Revenue Code of 1939
describes gross income as income derived from any source whatever. This Court has often
ruled that the broad language used in this definition allows Congress to exercise the full
extent of its taxing power. Thus, unless Congress expressly exempts a type of gain from
taxation, this Court must assume that it falls within the definition of gross income. Under this
definition, even windfalls, such as punitive damages, are gross income subject to taxation.
Here, Glenshaw and Goldman Theatres experienced considerable increases in wealth. The
money they acquired cannot be shielded from taxation simply because they were taken as
punishment from wrongdoers. Congress has made no provision or given any evidence of its
intent to exempt punitive damages from taxation. In fact, legislative history reveals that
Congress intends for statutory gross income to be all-inclusive. Therefore, the punitive damages
received by Glenshaw and Goldman Theatres are taxable as gross income. The Court of Appeals
for the Third Circuit is reversed.

Charley v. Commissioner

Rule of Law: An employees conversion of frequent flyer miles into cash in a travel account
created by an employer constitutes gross income.

Facts: Philip Charley (defendant) served as President of Truesdail Laboratories (Truesdail).

Charley frequently traveled for business and accrued many frequent flyer miles. At the time,
Truesdail had an unwritten policy that any frequent flyer miles accrued during business travel
were the personal property of the employees who accrued them. Throughout 1998, Charley took
four business trips. Each time, Truesdail paid its travel agent funds to obtain first class airfare for
Charley. But rather than purchasing a first class ticket, Charley instructed the agent to purchase a
coach ticket with the funds. Charley would then upgrade the ticket to first class using his
frequent flyer miles. The remainder of the original funds from Truesdail (the difference between
a first class ticket and a coach ticket) was deposited into Charleys personal travel account. In
this manner, Charley sold his frequent flyer miles to Truesdail and received cash in exchange.
By the end of the year, Charley had $3,149.93 deposited into his personal travel account. He did
not report the amount on his tax return. The Tax Court ruled that the frequent flyer miles were
taxable income.

Issue: Does an employees conversion of frequent flyer miles into cash in a travel account
created by an employer constitute gross income?

Holding and Reasoning (Farris, J.): Yes. According to 61 of the Internal Revenue Code,
gross income is income from virtually any source. In Commissioner v. Glenshaw, 348 U.S.
426 (1955), the Supreme Court described gross income as a clear attainment of wealth, over
which the taxpayer has complete control. Charley concedes that the frequent flyer miles
belonged to him and that he exercised complete control over them, but argues that a taxable
event did not occur. This court ultimately finds that Charley undeniably acquired wealth that is
subject to taxation. Two theories support this finding. First, this court can view the frequent
flyer miles converted to cash as additional compensation. Under this theory, Truesdail gave
Charley property in the form of a travel account. By allowing the travel agent to deposit the
difference between first class and coach airfare into Charleys travel account, Truesdail
compensated Charley in that amount. As compensation, the cash is taxable. In the alternative,
this court can assume that the frequent flyer miles always belonged to Charley, and that their
conversion into cash was a disposition of his personal property. Under 631(a)(3) of the Internal
Revenue Code, gains from the disposition of property constitute gross income. Such gains are
calculated by subtracting the propertys adjusted basis from the amount realized. The adjusted
basis is typically the cost of the property paid by the owner. The amount realized is the amount
received by the owner for the property. Here, Charley paid nothing for the frequent flyer miles.
Thus, the adjusted basis is zero. Charley received $3,149.93 for the frequent flyer miles. Since
the adjusted basis is zero, the entire $3,149.93 is taxable gain. Therefore, under either theory, the
conversion of the frequent flyer miles into cash constitutes taxable income. The Tax Court is
affirmed.

BUT NOTE: IRS RELEASED A NEWS THAT IT WILL NOT TAX FREQUENT
FLIER MILES
IMPUTED INCOME & GIFTS/INHERITANCE:

Helvering v. Independent Life Insurance Co.

Rule of Law: The rental value of a building occupied by its owner is not taxable as gross
income.

Facts: [Information not provided in casebook excerpt.]

Issue: Is the rental value of a building occupied by its owner taxable as gross income?

Holding and Reasoning (Butler, J.): No. While the Sixteenth Amendment gives Congress the
power to levy a tax on incomes without apportionment, Article I, 9 of the Constitution
requires that direct taxes be apportioned among the states. The rental value of the building
here does not constitute income as governed by the Sixteenth Amendment. It is a direct tax
governed by Article I, 9, which requires apportionment. Thus, Article I, 9 precludes a tax on
the rental value of the building as income.

Dean v. Commissioner

Rule of Law: A taxpayer who resides in property belonging to a corporation of which the
taxpayer and his wife are the sole shareholders should include the rental value of the
property as gross income.

Facts: Dean (defendant) and his wife owned and occupied property. They were also the sole
shareholders of Nemours Corporation. As president, Dean was on Nemours Corporations
payroll. In 1931, the couple transferred the property to the corporation, but continued to live
there. The Commissioner determined that Dean owed income taxes on the rental value of
the property. The Tax Court ruled in the Commissioners favor.

Issue: Should a taxpayer who resides in property belonging to a corporation of which the
taxpayer and his wife are the sole shareholders include the rental value of the property as
gross income?

Holding and Reasoning (Goodrich, J.): Yes. Under Chandler v. Commissioner (1941), a taxpayer
who resides free of charge in a property owned by a corporation, of which he is an employee and
shareholder, receives income in an amount equal to the fair rental value of the property. In this
case, Dean had a legal duty to provide a home for his family. He did so by occupying property
provided free of charge by Nemours Corporation. As an officer of the corporation, the rent-free
occupancy of the property constituted compensation to Dean. Therefore, the rental value of his
occupancy must be included as gross income. The decision of the Tax Court is affirmed.

Commissioner v. Duberstein

Rule of Law: A transfer is not a gift if made out of obligation or anticipation of future
benefits.
Facts: Duberstein and Stanton (defendants) were unrelated taxpayers who failed to include as
gross income the receipt of what they believed to be gifts. Duberstein was president of
Duberstein Iron & Metal Company, which conducted business with Mohawk Metal Corporation
(Mohawk). Berman, the president of Mohawk, would occasionally ask Duberstein for the names
of people who might be interested in purchasing Mohawks products. On one occasion,
Duberstein did provide the names of potential customers for Berman. Berman later contacted
Duberstein, stating that Dubersteins tips had proven so valuable that Berman wished to provide
him with a car in appreciation. Mohawk later denoted the value of the car as a business
expense on its corporate tax return. Believing that the car was a gift, Duberstein did not
include the value of the car as gross income on that years tax return. The Commissioner found a
deficiency in Dubersteins return in the amount of the cars value. The Tax Court agreed. The
Court of Appeals for the Sixth Circuit reversed. In a separate case, Stanton was an employee of a
church for approximately ten years. In 1942, he left the church to begin his own business. Upon
his resignation, his employer passed a resolution to grant him a total of $20,000 in appreciation
for his services, to be dispensed in monthly installments. The resolution relieved the employers
of any obligation to pay Stanton a pension or retirement benefit, although the employer did not
have any such obligation at the time. Stanton was not required to perform any further services for
the church. He did not report the receipt of the monthly installments on his income tax return for
that year. The Commissioner found a deficiency in the amount of the monthly installments.
Stanton paid the deficiency but subsequently sued in the United States District Court for the
Eastern District of New York for a refund. The District Court found the payments were a gift and
ruled in Stantons favor. The Court of Appeals for the Second Circuit reversed. The United
States government sought review of both cases, requesting clarification of what constitutes a gift.
The United States Supreme Court granted certiorari.

Issue: Is a transfer a gift if made out of obligation or anticipation of future benefits?

Holding and Reasoning (Brennan, J.): No. Gifts received are excluded from gross income. But
precisely what constitutes a gift is not a simple determination. If the transfer is made from a
sense of obligation or in exchange for services, the transfer is not a gift. The transfer must be
entirely voluntary. But even a voluntary transfer is not necessarily a gift. The transferor must
lack any ulterior motive or desire to secure a benefit. In other words, the transfer must be made
out of a detached and disinterested generosity. Furthermore, the transferors mere
characterization of the transfer as a gift is insufficient. The controlling factor is the
transferors intent. Courts must look to the transferors dominant purpose in making the
transfer to determine whether the transfer is truly a gift. The Government seeks a more
definite test to determine whether a transfer is a gift, and suggests that only transfers made in a
personal context, as opposed to a business context, should qualify as a gift. Although indeed rare
that a transfer in a business context is truly a gift, the Governments proposed test is too broad to
serve as a universal rule of law. Whether a transfer is a gift is a determination that is governed by
the particular facts of any given case. Because this issue is determined on a case-by-case basis,
appellate courts must review a fact-finders decision with considerable deference. An appellate
court should only overturn a judges decision if it is clearly erroneous or a jurys decision if no
reasonable person could reach the same conclusion. In Dubersteins case, the Tax Courts
decision was not clearly erroneous. Although Berman and Duberstein characterized the transfer
as a gift, and although Berman had no legal or moral obligation to make the transfer, the trial
court was nevertheless justified in finding the transfer was not a gift. The transfer was made
primarily in response to the assistance provided by Duberstein, or perhaps in order to secure
Dubersteins continued assistance. Thus, the judgment of the Court of Appeals for the Sixth
Circuit is reversed. In contrast, this Court finds that the decision of the district court in Stantons
case was insufficiently supported. The district court made a cursory finding that the transfer was
a gift, without determining sufficient facts or indicating a legal standard that an appellate court
could review. Therefore, this Court vacates the judgment of the Court of Appeals for the Second
Circuit and remands the case back to the district court.

Concurrence/Dissent (Frankfurter, J.): The majoritys restatement of already existing law is

likely to confuse the lower courts. The lower courts should simply be left to apply the language
already established by previous case law. The majority also indicates that fact-finders should rely
on their personal experiences with human conduct when making tax determinations. However,
given the vast diversity of human experiences, such an approach is likely to destroy attempts at
uniformity in tax law. To the extent that this Court has applied what prior case law has already
established, the Court properly reversed the judgment in Dubersteins case. But the decision in
Stantons case should have been affirmed.

Lyeth v. Hoey

Rule of Law: Property is exempt from income as an inheritance even if the property is
distributed according to a compromise agreement settling a contest of the decedents will.

Facts: After the death of his grandmother in 1931, the petitioner (defendant) was deemed one of
several heirs to her estate. The grandmothers will left small legacies to each of her heirs and left
the remainder of her estate, which equaled to over $3,000,000, to the trustees of the Endowment
Trust. The grandmothers heirs contested the will in probate court, alleging lack of testamentary
capacity and undue influence. Before a jury could hear the case, the parties entered into a
compromise agreement by which the bequest to the Endowment Fund was invalidated. Under the
terms of the compromise agreement, the heirs received $200,000, the Endowment Fund received
$200,000, and the heirs and the trustees of the Endowment Fund equally divided the remainder
of the estate. The probate court approved the compromise agreement and the petitioner received
his share of the estate in 1933. The Commissioner valued the petitioners share at $141,484.03
and deemed it income. The petitioner paid a $56,389.65 tax on the amount and subsequently
filed a claim for a refund. The claim was rejected. The petitioner then brought suit in the District
Court, which held in his favor. The Court of Appeals, relying on Massachusetts inheritance law,
reversed. The United States Supreme Court granted certiorari.

Issue: Is property exempt from income as an inheritance even if the property is distributed
according to a compromise agreement settling a contest of the decedents will?

Holding and Reasoning (Hughes, C.J.): Yes. Under the Revenue Act of 1932, property
received by inheritance is excluded from gross income. Where property is distributed
according to the terms of a decedents will, there is no question that the property received
is an inheritance. But in situations where the validity of a will is contested, interested parties
may reach a compromise agreement that overrules the will. It is unclear whether property is
inheritance if it is distributed according to the terms of a compromise agreement, rather than the
decedents will. Because this is an issue involving Congress power to tax, it is governed by the
intent of Congress, and not the intent of state legislatures. Thus, the Court of Appeals erred in
relying on Massachusetts inheritance law to determine that the petitioner did not receive the
property by inheritance. Examining congressional intent behind the Revenue Act, it is apparent
that Congress intended to consider all acquisitions from a decedents estate as an inheritance.
Here, the petitioners status as heir suggests the distribution should be deemed an inheritance.
The petitioner only had the power to contest the will and enter into a compromise agreement
because of his status as an heir. Furthermore, the petitioner only received his share of the
estate, as distributed according to the compromise agreement, due to his status as an heir.
The form of distribution does not change the nature of the petitioners status as heir, by which he
was entitled to receipt of the property. It is apparent that had the petitioners contest of the will
led to a judgment, rather than a compromise agreement, any distribution to the petitioner
according to the judgment would be an inheritance. It should make no difference that the
property was distributed according to a compromise agreement rather than a judgment of the
probate court. For these reasons, this Court finds that the property distributed to the petitioner is
an inheritance exempt from income. The Circuit Court of Appeals is reversed and the District
Court is affirmed.

Wolder v. Commissioner

Rule of Law: A bequest made in return for lifetime legal services constitutes taxable
income.

Facts: Around October 3, 1947, Victor R. Wolder (defendant) and Marguerite K. Boyce entered
an agreement. The agreement specified that Wolder, an attorney, would provide legal services
for Boyce free of charge for the rest of her life. In return, Boyce would bequeath any securities
she might obtain should a corporation by the name of White Laboratories undergo a merger or
consolidation. White Laboratories subsequently merged with Schering Corporation. Boyce
received 750 shares of one type of stock and 500 shares of another. Boyce later exchanged the
500 shares for $15,845. Over the course of Boyces life, Wolder upheld the agreement by
providing legal services without charge. Boyce also upheld the agreement by bequeathing to
Wolder her 750 shares and the $15,845. The Tax Court held that the fair market value of the
shares and the $15,845 was taxable income for services rendered, and not a bequest exempt from
taxation.

Issue: Does a bequest made in return for lifetime legal services constitute taxable income?

Holding and Reasoning (Oakes, C.J.): Yes. Generally, gross income includes all income from
whatever source derived. One exception is that property acquired by bequest does not
constitute gross income. But where a bequest is made in return for services rendered, that
bequest should constitute taxable gain. Under Commissioner v. Duberstein, 363 U.S. 278
(1960), the Supreme Court held that the question of whether a transfer was a gift was determined
by the transferors primary reason for making the transfer. Similarly, in order to determine
whether a transfer should be treated as a bequest, this court must look to the intent of the
decedent in making the bequest. If the purpose of the bequest is to compensate for services
rendered, the bequest constitutes taxable income. Here, the agreement between Wolder and
Boyce contained mutual promises. It basically arranged for Boyce to provide postponed payment
for Wolders provision of lifetime legal services. Hence, Boyces true intention in leaving the
bequest was to make payment for services rendered by Wolder. Therefore, the bequest
constituted taxable gain to Wolder.
FRINGE BENEFITS

Herbert G. Hatt v. Commissioner

Rule of Law: The rental value of housing provided by an employer and located on the
business premises is excluded from gross income where acceptance of such housing is a
condition of employment and the housing is provided for the convenience of the employer.

Facts: Herbert G. Hatt (defendant) met and married Dorothy Echols, the president and majority
stockholder of Johann. Johann was an Indiana corporation that ran a funeral home in Evansville,
Indiana. After Hatt and Echols married, Echols transferred a majority of her shares to Hatt and
made him president and general manager of Johann. Hatt moved in with Echols, who lived in an
apartment in the same building as the funeral home. An ambulance crew, which the funeral home
oversaw, also lived in the building. After business hours, Johann handled business calls and met
with customers in his apartment. Evidence demonstrates that it was customary in the area for
funeral homes to have someone live in the same building as the funeral home in order to
accommodate customers.

Issue: Whether the rental value of housing provided by an employer and located on the
business premises is excluded from gross income where acceptance of such housing is a
condition of employment and the housing is provided for the convenience of the employer.

Holding and Reasoning: Yes. Where housing is provided to an employee by an employer, the
rental value of the housing may be excluded from the employees gross income if: (1) the
housing is located on the employers business premises; (2) the employee accepts the housing as
a condition of employment; and (3) the housing is provided for the convenience of the employer.
An employee accepts the housing as a condition of employment if his continuous presence is
necessary in order to adequately perform his duties. It is true that, as president and majority
stockholder of Johann, Hatt had the authority to determine the conditions of his own
employment, as well as to determine what was truly convenient to Johann as an employer.
Furthermore, it is arguable that the presence of an ambulance crew on the premises may have
made Hatts continuous presence unnecessary. Nevertheless, the nature of Hatts occupation
required him to live on the premises both as a condition of employment and for the convenience
of Johann as an employer. A funeral home business requires the continuous presence of an
employee authorized to deal with customers and handle the affairs of the business. For this
reason, every other funeral home in the area had such a designated employee. Here, Hatt was the
designated employee, and accordingly answered phone calls and met with customers at all hours
of the day. The ambulance crew did not have the authority to handle the affairs of the funeral
home, and therefore, Hatts continuous presence on the premises was necessary. Therefore, the
rental value of Hatts apartment is excluded from gross income.
AWARDS & SCHOLARSHIPS

Allen J. McDonell v. Commissioner

United States Tax Court
26 T.C.M.115 (1967)

Rule of Law: The expenses for a trip paid for by an employer is not included as gross
income if the trip is not provided in light of the employees past work performance and is
taken primarily for business purposes.

Facts: Allen J. McDonell (plaintiff) was a home office salesman for Dairy Equipment Co.
(DECO). In 1959, DECO held a sales contest for its distributors and salesmen. Each winner was
to receive a free trip to Hawaii with his wife. McDonell, as a home office salesman, was
ineligible for the contest. However, DECO management ordered McDonell and his wife to
accompany three of the contest winners and their wives to Hawaii in 1960. McDonells role was
to ensure that informal discussions about DECO did not lead to complaints and thereby damage
DECOs reputation with the winners. The presence of McDonells wife was deemed necessary to
assist him in hosting a trip for couples. DECO instructed McDonell that the trip was not a
vacation but an assignment. He and his wife were to stay continuously with the winners and were
forbidden from taking personal time during the trip. McDonell was one of four home office
salesmen selected that year to accompany four different groups of winners. Each home office
salesman was selected at random. Their selection had no correlation to their work performance,
and a home office salesmans selection one year did not prevent his selection the next year. They
did not receive a pay cut for the duration of the trip and did not lose vacation time. McDonell and
his wife left for Hawaii for ten days in February 1960. They stayed with the winners as instructed
and did not take any spare time for themselves. The cost of the trip for McDonell and his wife
was valued at $1,121.96. McDonell reported $600 in commissions on his 1960 tax return for the
cost of his wifes trip. His tax return was found to have a deficiency in the amount of $1,121.96.
McDonell argues that the entire cost of the trip was not income and that he erroneously reported
the $600 as income.

Issue: Are expenses for a trip paid for by an employer included as gross income if the trip
is not provided in light of the employees past work performance and is taken primarily for
business purposes?

Holding and Reasoning (Tannenwald, J.): No. Whether a trip paid for by an employer constitutes
a business trip or a taxable award depends on the specific circumstances surrounding the
employees participation. The presence of a business purpose or the obligatory nature of a trip
are significant, but not conclusive, indications of a business trip. Other important considerations
include whether the employees selection for the trip is based on work performance or whether
the destination is a typical vacation area. Here, DECOs selection of McDonell and his wife
for the trip to Hawaii did not constitute an award or compensation. DECO required
McDonell and his wife to take the trip in order to enhance DECOs image in the eyes of its
salesmen. DECO expressly told McDonell not to consider the trip a vacation and made it clear
that the trip was part of his obligations as a home office salesman. Because the trip was for
couples, the presence of McDonells wife was deemed integral to the success of McDonells
assignment. The fact that the trip was an award for the contest winners does not render the trip an
award to McDonell and his wife. Although the trip was designed for contest winners, McDonell
was not a contest participant, and was not selected for the trip on the basis of his work
performance. Rather, he was selected in order to discharge his obligations as a home office
salesman. Although the trip destination happens to be a popular resort area, McDonell and his
wife worked essentially the entire time, taking no personal time to enjoy it. In light of these
circumstances, it is clear that the trip was not provided as an award or disguised compensation.
The value of the trip is not gross income to McDonell or his wife.

Philadelphia Park Amusement Co. v. United States

Rule of Law: The cost basis of property received in a taxable exchange is the fair market
value of the property received.

Facts: In 1889, Philadelphia Park Amusement Co. (Philadelphia Park) (plaintiff) received a 50-
year franchise from the city of Philadelphia to run a passenger railway in Fairmont Park. In 1934,
Philadelphia Park received a ten-year extension on the franchise. In exchange for the extension,
Philadelphia Park deeded to the city Strawberry Bridge, which it had built over the Schuylkill
River. By 1946, Philadelphia Park abandoned the franchise. It later attempted to take
depreciation deductions based on the cost of the abandoned ten-year extension. The
Commissioner (defendant) disputed the value of Philadelphia Parks cost basis in the extension.

Issue: Is the cost basis of property received in a taxable exchange the fair market value of
the property received?

Holding and Reasoning (Laramore, J.): Yes. The Tax Code defines the basis of property
received in a taxable exchange as the cost of the property. In some cases, the Commissioner
has held that the basis of property received in a taxable exchange is the fair market value
of the property given. This interpretation is based on the idea that the cost of the property
received is equal to the value of what the taxpayer gives up in return. However, basis is
purely a tax concept designed to accurately assess a taxpayers liability for a gain or loss in
property. In order to prevent distorted assessments of liability against taxpayers, this court
believes that the cost basis of property received in a taxable exchange should be the fair market
value of the property received. Otherwise, in exchanges where the fair market value of the
property given is greater than the fair market value of the property received, the taxpayer would
receive a stepped-up basis without paying tax accordingly. Or, in exchanges where the fair
market value of the property given is less than the fair market value of the property received, the
taxpayer would be taxed twice. The taxpayer would be taxed once for the gain received in the
exchange and taxed again for any gain later realized. To avoid such consequences, the cost basis
of property received in a taxable exchange must be the fair market value of the property
received. Thus, in the transaction at issue, Philadelphia Park must use the fair market value of
the franchise extension as its cost basis. Here, the fair market value of the franchise extension is
likely to be equal to the fair market value of Strawberry Bridge at the time of exchange, since the
exchange was an arms-length transaction. Thus, if the precise value of the ten-year franchise
extension cannot be accurately assessed, the value of Strawberry Bridge will suffice as the value
of the extension. Philadelphia Park argues that the fair market value of both the bridge and the
extension cannot be determined, and that it should therefore be allowed to use the un-depreciated
cost of the bridge as the cost basis of the extension. Although valuation of the extension may
indeed be difficult, the value of Strawberry Bridge should be easily determined. Therefore,
judgment is suspended and the case is remanded to the Commissioner of this court to determine
the fair market value of the franchise extension.

Taft v. Bowers

Rule of Law: The increase in the value of property during a donors ownership is
assessable as income against the donee.

Facts: Elizabeth C. Taft (plaintiff) received 100 shares of stock from her father as a gift in 1921
and 1922. Tafts father had purchased the shares in 1916 for $1,000. At the time of transfer, the
shares of stock had appreciated to $2,000. In 1923, Taft sold the shares for $5,000. The United
States calculated a $4,000 increase in income based on the $1,000 appreciation during the
fathers ownership and the $3,000 appreciation during Tafts ownership, and taxed Taft
accordingly. Taft paid the tax but subsequently sued for a refund, arguing that only the $3,000
increase during her ownership was income, and that the Sixteenth Amendment prevented
Congress from taxing her for any increase during her fathers ownership. The District Court held
in Tafts favor. The Court of Appeals reversed. The United States Supreme Court granted
certiorari.

Issue: Is the increase in the value of property during a donors ownership assessable as
income against the donee?

Holding and Reasoning (McReynolds, J.): Yes. The Sixteenth Amendment allows Congress to
tax income from any source. This includes gains realized through the sale of capital assets, such
as stock. If a taxpayer sells property that has increased in value during his ownership, there
would be no question that Congress has the power to tax the realized gain. The result should be
no different if the taxpayer chooses to gift the shares instead. Congress retains the right to tax the
appreciation in value once it is realized, albeit at a postponed date. To hold otherwise would
interfere with Congress intent to take a portion of all gains from the sale of assets. It is therefore
not unreasonable or arbitrary of Congress to tax Taft for the appreciation in value during both her
and her fathers ownership of the shares. Tafts father owned shares of stock that increased in
value by $1,000 during his ownership. When he transferred the shares to Taft, the increase was
not realized because it was a gift. By accepting the gift, Taft received the shares subject to
Congress right to eventually tax the $1,000 increase whenever it was realized. It happened that
it was not realized until Taft sold the shares in 1923. At that time, she became liable for taxes on
the entire increase in value since 1916. The judgment of the Court of Appeals is affirmed.

Farid-Es-Sultaneh v. Commissioner

Rule of Law: The lack of fair consideration in a purchase agreement does not render the
transfer a gift for the purpose of assessing taxable income against the recipient.
Facts: In December 1923, S.S. Kresge transferred 700 shares of the S.S. Kresge Company to
Farid-Es-Sultaneh (plaintiff). Kresge and Farid-Es-Sultaneh planned to wed after Kresge
obtained a divorce from his wife. The shares of stock, each with a fair market value of $315,
were intended as financial protection for Farid-Es-Sultaneh in the event that Kresge should pass
away before their marriage took place. Kresge obtained his divorce on January 9, 1924, and
transferred another 1,800 shares of stock to Farid-Es-Sultaneh on January 23, 1924. At the time,
the stock was worth $330 per share. Before marrying in April 1924, Kresge and Farid-Es-
Sultaneh signed an ante-nuptial agreement. The agreement specified that in consideration of the
shares received by Farid-Es-Sultaneh and Kresges agreement to marry her, Farid-Es-Sultaneh
would relinquish all marital rights, including her right to financial support as Kresges wife. The
two were married until their divorce in 1928. In 1938, Farid-Es-Sultaneh sold 12,000 shares of
the stock for $230,802.36. By that time, the number of shares she owned had increased due to the
payout of multiple stock dividends. It was calculated that if Farid-Es-Sultaneh purchased the
stock, her adjusted basis would be $10.66 2/3 per share, based on the fair market value of the
shares at the time she received them. On the other hand, if the shares were a gift to Farid-Es-
Sultaneh rather than a purchase, she assumed Kresges adjusted basis of $0.159091 per share.
Farid-Es-Sultaneh believed that she purchased the stock through her pre-nuptial agreement with
Kresge, and accordingly used the fair market value of the stock at the time she received them as
her adjusted basis. The Commissioner (defendant) determined the stock was a gift, and that
Farid-Es-Sultaneh should have used Kresges adjusted basis in calculating taxable gain. The Tax
Court agreed with the Commissioner.

Issue: Does the lack of fair consideration in a purchase agreement render the transfer a gift
for the purpose of assessing taxable income against the recipient?

Holding and Reasoning (Chase, J.): No. When property is purchased, the recipients cost basis in
the property is its fair market value at the time of purchase. But where property is transferred as a
gift, the recipient adopts the donors cost basis in the property. Here, the Commissioner
characterizes the transfer of stock to Farid-Es-Sultaneh as a gift rather than a sale because Farid-
Es-Sultaneh did not provide fair consideration in exchange for the stock. The Commissioner
borrows the requirement of fair consideration from estate and gift tax laws. The estate tax law
requires that property transferred by a decedent in contemplation of his or her death should be
included in the decedents gross estate, unless the transfer is a bona fide sale for fair
consideration. Similarly, gift tax law requires that a transfer of property be treated as a gift unless
fair consideration is given in exchange for the property. In Commissioner v. Wemyss, 324 U.S.
303 (1945), the Supreme Court contemplated whether a transaction was a gift in order to
determine whether a gift tax should be imposed on the transferor. The transfer had taken place
pursuant to an ante-nuptial agreement, in which Wemyss transferred property to his future wife
in exchange for her promise to marry him and in exchange for her loss in trust income that would
result upon their marriage. The Supreme Court held that there was a lack of adequate
consideration and treated the transfer as a gift. Thus, it is well established that fair consideration
is required in order to avoid the imposition of a gift tax. But this case involves the income tax
liability of Farid-Es-Sultaneh, not the gift tax liability of Kresge. Even if the consideration given
by Farid-Es-Sultaneh is inadequate under gift tax standards, it does not render the transfer of
stock a gift under income tax standards. Congress has not indicated that the requirement of fair
consideration should be imported into the income tax law, and this court will not do so except by
Congress direction. The question of whether Farid-Es-Sultaneh gave adequate consideration for
the stock is inapplicable here. Under income tax laws, the presence of any consideration in
the ante-nuptial agreement negates the possibility that the shares were a gift, since gifts
must be made with a purely donative intent. While true that Farid-Es-Sultaneh and Kresge
referred to the shares as a gift in the ante-nuptial agreement, the gift was contingent upon
Kresges death, which did not occur. Instead, Farid-Es-Sultaneh gave up her marital rights in
return for the stock and thereby purchased it. The decision of the Tax Court is therefore reversed.

International Freighting Corporation, Inc. v. Commissioner

Rule of Law: The disposition of stock in exchange for services rendered is a taxable event.

Facts: In 1936, International Freighting Corporation, Inc. (International Freighting) (plaintiff)

issued bonuses in the form of 150 shares of stock to its employees. Altogether, the bonus stock
had a fair market value of $24,858.75. International Freighting had only paid $16,153.36 for
them. International Freighting deducted $24,858.75 as a business expense for that year. The
Commissioner (defendant) reduced the amount of the deduction, arguing that by paying the
bonus in the form of property, the value of the business expense was equal to the cost of the
property, which was only $16,153.36. International Freighting brought this action in the Tax
Court to determine the proper amount of the deduction. The Commissioner argued that if the
entire $24,858.75 were deductible, then the Tax Court must also find that International
Freighting realized a gain of $8,705.39 upon disposition of the stock. The Tax Court ruled that
the entire $24,858.75 was deductible as a business expense but that International Freighting
realized $8,705.39 in taxable income by disposing of the shares.

Issue: Is the disposition of stock in exchange for services rendered a taxable event?

Holding and Reasoning (Frank, J.): Yes. Upon disposition of property, any gain realized is
taxable as income. Gain is calculated by subtracting the adjusted basis, or cost, from the amount
realized. The amount realized is the sum of any money and property received from the
disposition. In situations where services are received instead of money, the value of the services
received operates as the amount realized. By issuing bonus shares to its employees in exchange
for their services, International Freightings assets were decreased in an amount equal to the
value of the shares. Thus, regardless of what International Freighting paid for the shares, the
bonuses amounted to a $24,858.75 business expense, which International Freighting properly
deducted on its tax return. However, the transaction is not simply a payment of bonuses as
additional compensation. It is a taxable event whereby International Freighting disposed of its
stock for a value greater than its cost. International Freighting realized an amount of $24,858.75
in employee services but only had an adjusted basis in the stock of $16,153.36. This amounts to
an $8,705.39 taxable gain. Accordingly, the judgment of the Tax Court is affirmed.
Crane v. Commissioner

Rule of Law: The amount realized in the disposition of property subject to an unassumed
mortgage includes the amount of the mortgage.

Facts: Upon the death of her husband in 1932, Crane (plaintiff) became the beneficiary of an
apartment building and lot. The building and lot were subject to a mortgage, consisting of a
principal debt of $255,000.00 and interest in default of $7,042.50. The value of the property for
estate tax purposes was the amount of the entire encumbrance, or $262,042.50. For the next
seven years, Crane managed the property and collected rents for the mortgagee. During this time,
she took deductions related to the property, including deductions for property depreciation. By
1938, the interest owed had increased and the mortgagee threatened to foreclose. At that time,
Crane sold the property and received, after expenses, $2,500.00. In calculating her gain in the
sale of the property, she believed that the term property referred to her equity in the building
and lot. Under this theory, the property she acquired was the value of the building and lot less the
amount of the mortgage. In other words, she had zero equity in the building, which she later sold.
Crane found the amount realized in the sale to be $2,500.00 and the cost basis to be zero.
Because the Tax Code requires reporting of only half the amount realized in the sale of a capital
asset held for more than two years, Crane reported only $1,250.00 as taxable gain. The
Commissioner (defendant), on the other hand, argued that property referred to the building and
lot itself, not their equity. According to the Commissioner, the original basis was the 1932
appraisal value of $262,042.50 and, because Crane had taken depreciation deductions on the
building, he adjusted the basis accordingly. He calculated the amount realized to include the
principal amount of the mortgage in addition to the $2,500.00 net profit, totaling $257,500.00.
The case was heard in the Tax Court to determine Cranes taxable gain. The Tax Court held in
Cranes favor. The Court of Appeals reversed. The United States Supreme Court granted
certiorari.

Issue: Does the amount realized in the disposition of property subject to an unassumed
mortgage include the amount of the mortgage?

Holding and Reasoning (Vinson, C.J.): Yes. A taxpayers gain from the disposition of property is
calculated by subtracting the adjusted basis from the amount realized. The adjusted basis is
found by adjusting the original basis for certain factors, such as depreciation. The amount
realized is calculated by adding any money and property received. Where, as here, the taxpayer
receives the property from a decedents estate, the original basis is the fair market value at the
time of receipt. In order to ascertain the adjusted basis and amount realized for Cranes property,
it is first necessary to determine what the term property refers to. There are several reasons this
Court does not adopt Cranes argument that it refers to equity. First, the plain meaning of the
term suggests that property refers to the physical thing that is owned. Second, administrative
regulations have used the term to refer to physical property. Third, in other provisions of the
Revenue Code, Congress clearly distinguishes between property and equity and there is no
indication that Congress interchanges the two terms. Third, if property referred to equity,
depreciation deductions based on equity would be miniscule. Or, if depreciation deductions were
based on the actual value of the property and deducted from an equity basis, negative deductions
would result. Thus, interpreting the term to mean equity would negate the purpose of allowing
depreciation deductions in the first place. Furthermore, if property is based on equity, the
taxpayers basis would change every time a mortgage payment is made, causing a great
administrative burden on both the Commissioner and taxpayers. For these reasons, this Court
holds the term property refers to actual property in the ordinary sense of the word.
Accordingly, Cranes original basis in the building and land is its fair market value of
$262,042.50, not its equity of zero value. Because the Tax Court found Cranes basis to be
zero, it did not adjust the basis for depreciation. But because the basis is in fact
$262,042.50, an adjustment should be made to account for the depreciation deductions
taken by Crane over the years. Once the adjusted basis is determined, the next step is to
determine the amount realized from the sale of the property. Crane incorrectly believed the
amount realized was $2,500.00, because the amount of mortgage on a property is included in the
amount realized from its sale. It makes no difference whether the taxpayer is personally liable for
the mortgage or not. A taxpayer who sells property subject to a mortgage receives a benefit equal
to the value of the mortgage. For this reason, the amount realized by Crane included both the
$2,500.00 boot as well as the principal amount of the mortgage, which altogether totaled
$257,500.00. Crane argues that as a result of these calculations, she has been taxed beyond the
limits of the Sixteenth Amendment. Simply put, it is not unconstitutional to adjust her cost basis
by the amount of the depreciation deductions she took on the property, in order to determine how
much she has gained from the sale. The decision of the Court of Appeals is affirmed.

Dissent (Jackson, J.): The Tax Court did not err in finding that Crane received an equity of zero
value. Nor did she benefit in the amount of the mortgage when she disposed of the property. She
was not personally liable for the mortgage, and her sale of the property subject to the mortgage
did not release her from any debt. The decision of the Court of Appeals should be reversed and
the decision of the Tax Court should be sustained.

Commissioner v. Tufts

Rule of Law: The amount realized in the disposition of property subject to a nonrecourse
mortgage includes the entire amount of the mortgage regardless of whether the mortgage
exceeds the fair market value of the property.

Facts: Pelt, Tufts, Steger, Stephens, and Austin (plaintiffs) formed a general partnership for the
purpose of building an apartment complex. The partnership obtained a nonrecourse mortgage on
the building in the amount of $1,851,500. The complex was completed in 1971, whereupon the
partners made capital contributions in the amount of $44,212. In 1971 and 1972, each partner
took depreciation deductions totaling $439,972. In light of their capital contributions and
depreciation deductions, their adjusted basis in the property in 1972 was $1,455,740. But due to
economic problems in the area, the partnership was unable to pay the mortgage. Eventually, each
partner sold his share to a third party, who assumed the nonrecourse mortgage. At the time, the
fair market value of the property was about $1,400,000. Because the fair market value was lower
than their adjusted basis, each partner reported a partnership loss of $55,740 from the sale. But
the Commissioner (defendant) found the amount realized by the sale included the amount of the
unpaid mortgage, even though the mortgage exceeded the fair market value of the building, and
determined the partnership had realized a capital gain of about $400,000. The Tax Court agreed
with the Commissioner. The Court of Appeals reversed. The United States Supreme Court
granted certiorari.

Issue: Does the amount realized in the disposition of property subject to a nonrecourse
mortgage include the entire amount of the mortgage regardless of whether the mortgage
exceeds the fair market value of the property?

Holding and Reasoning (Blackmun, J.): Yes. In Crane v. Commissioner, 331 U.S. 1 (1947), this
Court held that a taxpayer who sells property subject to a nonrecourse mortgage must include
the unpaid balance of the mortgage in the amount realized. Generally, with a nonrecourse
mortgage, the mortgager is not personally liable for the loan. The mortgage is secured by
property, so that the mortgager is only liable up to the fair market value of the property. Upon
sale of the property subject to a nonrecourse loan, the mortgager must calculate the amount
realized. The amount realized includes the sum of money and property received, as well as any
debts the mortgager is relieved of through the transaction. Though a taxpayer could technically
only be relieved of liability equal in value to the fair market value of the property, the
mortgager must include the entire amount of the unpaid mortgage in the amount realized.
This is because the taxpayer receives certain benefits based on the assumption that the taxpayer
is obligated to repay the entire nonrecourse mortgage. For instance, the taxpayer receives a
nonrecourse mortgage tax-free, since it is money the taxpayer must eventually pay back. If, after
receiving the mortgage tax-free, the taxpayer does not include the entire unpaid loan in the
amount realized upon disposition of the property, he receives the amount in excess of the fair
market value of the property tax-free. Furthermore, a taxpayer is allowed to include the entire
amount of a nonrecourse loan in his cost basis of the property because he is expected to repay the
entire loan. If he is not correspondingly required to include the entire unpaid loan in the amount
realized, the taxpayer would receive an untaxed increase in basis. To prevent such incongruities,
a taxpayer must include the entire unpaid amount of a nonrecourse mortgage in his amount
realized, regardless of whether the mortgage exceeds the fair market value of the property. Here,
the defendants received the $1,851,500 mortgage tax-free and included the entire amount in their
basis. When they were unable to pay their mortgage, they were only liable up to the fair market
value of the apartment complex, which was about $1,400,000. But because they received tax
benefits on the assumption that they would repay the entire $1,851,500, the inclusion of the
entire unpaid mortgage in their amount realized is warranted. To allow the defendants to count
only the propertys fair market value in the amount realized would allow them to claim a capital
loss of $55,740 when they did not actually sustain an economic loss. This Court therefore holds
that the Commissioner properly included the entire amount of the defendants unpaid mortgage
in the amount realized. The judgment of the Court of Appeals is reversed.

Concurrence (OConnor, J.): In light of Crane, certain established tax regulations, and many
lower court decisions, the majority properly adopted the Commissioners approach. However, if
this Court were free to adopt a new approach, it would be wiser to treat the disposition of the
property separately from the cancellation of the debt. They are different types of transactions
under the Tax Code. Certain sales of property may be treated as capital gains, while gains from
the cancellation of debts are treated as ordinary income. Handling the two types of income
differently would ensure the Tax Code is properly applied. But because the Commissioners
approach does not exceed the bounds of his authority, this Court must defer to it.
INSURANCE PROCEEDS & ANNUITY PAYMENTS [NO CASES]

DISCHARGE OF DEBT

Zarin v. Commissioner

Rule of Law: The discharge of indebtedness resulting from a settlement fixing the amount
of a disputed debt is not taxable as income.

Facts: David Zarin (plaintiff) applied for and received a credit line from Resorts International
Hotel (Resorts), which ran a gambling establishment in New Jersey. Under the terms of the line
of credit, Resorts advanced chips to Zarin, which he used to gamble at the hotel. Zarin soon
became an excessive gambler and received regular increases on his credit limit. By November
1979, his line of credit had a limit of $200,000. That year, the Casino Control Commissioner
issued an Emergency Order that effectively prohibited casinos from making extensions of credit
to Zarin. Despite this, Resorts continued to increase Zarins credit line. In 1980, Zarin had
amassed a debt of $3,435,000. He wrote personal checks to Resorts to pay the debt, but the
checks bounced. As a result, Resorts sued Zarin to recover the $3,435,000. Zarin argued Resorts
could not recover the amount owed because New Jersey regulations prohibited it. The parties
eventually settled, agreeing that Zarin owed only $500,000. The Commissioner argued that the
reduction in Zarins debt amounting to $2,935,000 was a discharge of indebtedness, and was
therefore income to Zarin. The Tax Court agreed.

Issue: Whether a discharge of indebtedness resulting from a settlement fixing the amount
of a disputed debt is taxable as income.

Holding and Reasoning (Cowen, J.): No. According to 108 and 61(a)(12) of the Tax Code, a
taxpayer who is discharged from indebtedness realizes income in that amount. Sections 108 and
61(a)(12) are only applicable where a taxpayer has (1) an indebtedness for which he is liable or
(2) an indebtedness by which he holds property. Here, Zarin is not liable for the $3,435,000 debt.
Under New Jersey law, the debt is unenforceable. Because he has no legal obligation to pay the
debt, he is not liable. Zarin also does not owe debt subject to which he holds property. Although
Zarin acquired chips through his line of credit, the chips are not property. They have no use other
than for gambling and have no value outside of the casino. The chips are merely accounting
mechanisms used to indicate the amount of debt owed. Although chips can technically be
redeemed for cash, this is not the case for Zarin. Zarins debt always outweighed the amount of
chips he had, and thus he could never have received any cash or property of value in exchange
for the chips. Because Zarin was not liable for the debt and did not have debt subject to which he
held property, 108 and 61(a)(12) do not apply, and the discharge of Zarins debt did not result
in income. This court can properly view this issue as a case of contested liability. Where a
taxpayer contests his amount of debt in good faith, the resulting settlement is regarded as the
amount of debt, with no other tax consequences for the taxpayer. Any discharge of indebtedness
resulting from the settlement is disregarded. In N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263
(1939), a taxpayer contested a $21,700 loan he had taken from a bank. After settlement, the
taxpayer owed only half the original amount. The Board of Tax Appeals held that the discharged
portion of the note was not gain to the taxpayer. Similarly, in United States v. Hall, 307 F. 2d
238 (1962), a taxpayer amassed a $225,000 gambling debt that was unenforceable. He and his
creditors eventually agreed that he would only pay $148,110. The Tenth Circuit ruled that the
difference between the original debt and what he ultimately paid was not income. Here, Zarin
disputed the enforceability of the $3,435,000 debt he incurred. After settlement, he owed only
$500,000. Under Sorel and Hall, the $2,935,000 discharge of debt was not income to Zarin. The
Commissioner argues that the contested liability doctrine only applies when the amount of debt
is in question, not when the enforceability of the debt is disputed. But when the enforceability of
the debt is challenged, the amount of debt is challenged as well. Here, if the only question was
the enforceability of Zarins debt, Zarin would have either had to pay the entire debt or nothing
at all. But the parties reached a new amount in settlement, demonstrating that the amount
of liability was in fact in dispute until the settlement was reached. For the foregoing
reasons, the reduction in Zarins debt was not a discharge of indebtedness for the purposes
of computing taxable income. The judgment of the Tax Court is reversed and remanded, and
the Tax Court is instructed to enter a judgment that Zarin did not realize income through the
settlement with Resorts.

Dissent (Stapleton, J.): Zarin obtained the benefit of gambling at Resorts, which was valued at
$3.4 million. Because he was obligated to repay the $3.4 million, it was not counted as income
that year. But once Resorts relieved Zarin of the obligation to pay back $2.9 million of that debt,
that $2.9 million became income to Zarin. The judgment of the Tax Court should be affirmed.
CAPITAL ASSETS

Mauldin v. Commissioner

Rule of Law: Gain from the sale of property is entitled to capital gains treatment if the
property is held for investment purposes.

Facts: In 1920, C.E. Mauldin (plaintiff) entered an agreement to purchase 160 acres of land in
New Mexico. At the time, Mauldin intended to use the land for cattle feeding. However, by the
time he acquired the property in 1921, he had changed his mind, in part because the cattle
business was no longer a wise or profitable venture. In 1924, Mauldin attempted to sell the land
but was unable to do so. In order to facilitate its sale, Mauldin subdivided the land into small
lots. In 1939 and 1940, Mauldin actively sold a substantial number of lots by listing the property
with real estate agents and advertising the lots throughout town. At this point, Mauldin decided
to hold onto what remained of the original tract of land for investment purposes. He then entered
the lumber business in 1940, after which he no longer actively advertised the lots. However,
between 1940 and 1945, Mauldins land became the subject of popular demand. Thus, Mauldin
regularly sold lots between 1940 and 1945, selling a substantial portion of them in 1945. By
1945, Mauldin only had 20 acres remaining in his possession. A large portion of his income
during this time was attributable to the sale of lots. In his tax return for 1944 and 1945, Mauldin
characterized the lots he sold as long-term capital assets. The Commissioner (defendant)
disallowed this characterization and treated gain from the sales as ordinary income. The Tax
Court sustained the Commissioners ruling.

Issue: Is gain from the sale of property entitled to capital gains treatment if the property is
held for investment purposes?

Holding and Reasoning (Murrah, J.): Yes. Whether the disposition of property is entitled to
capital gains treatment is determined on a case-by-case basis. The primary consideration is the
purpose for which the property is held. If held in the ordinary course of business, any gains upon
disposition are taxable at ordinary income tax rates. If held for investment purposes, any gains
upon disposition are entitled to capital gains treatment. Another relevant factor is the purpose for
which the property is acquired, but this is not dispositive. Thus, in Richards v. Commissioner
(1936), a taxpayer who originally acquired land to use as a farm but later subdivided it and sold
the parcels was deemed to be in the business of selling real estate. The continuity and frequency
of property sales are other relevant factors. Taxpayers who continuously sell land and partition it
in order to facilitate sales are more likely engaged in the business of selling real estate than
taxpayers who only occasionally sell land. Here, Mauldin did not acquire the property to sell it in
the ordinary course of business. He purchased the land for cattle feeding, intending to go into the
cattle feeding business. But after abandoning the intent to enter the cattle feeding business, and
upon subdividing the land into parcels in order to facilitate sales, Mauldin clearly entered the
business of selling real estate. While Mauldin argues that he left the business of selling real
estate in order to start a lumber company in 1940, the record shows that he continuously sold lots
from 1940 to 1945, and that he made a substantial portion of his sales in 1945. A considerable
part of his income from 1940 to 1945 came from the sale of the lots. Based on these facts, this
court cannot say that the Tax Court was clearly erroneous in ruling that Mauldin was in the
business of selling real estate in 1944 and 1945. The judgment of the Tax Court is therefore
affirmed.

Malat v. Riddell

Rule of Law: A taxpayer holds property primarily for sale in the ordinary course of
business if such sale is of first and principal importance to the taxpayer.

Facts: Malat (plaintiff), as part of a joint venture, acquired a parcel of land. The joint venturers
encountered difficulties in obtaining zoning. As a result, they decided to end the venture and sell
the parcel. Malat characterized the proceeds from the sale as a capital gain. According to
Malat, the profits were entitled to capital gains treatment because the joint venturers purchased
the land with the intent to develop it for rental. Riddell (defendant) disagreed with Malats
characterization. Riddell argued that the joint venturers had a dual purpose in acquiring the land.
They intended to either develop the land for rental or for sale, depending on which option proved
more profitable. Riddell determined that Malat held the property primarily for sale in the
ordinary course of business and that therefore, the proceeds from the sale must be treated as
ordinary income. The District Court sustained Riddells determination, agreeing that the joint
venturers had a dual purpose in purchasing the property and that Malat failed to demonstrate that
the property was not held primarily for sale in the ordinary course of business. The Court of
Appeals affirmed. The United States Supreme Court granted certiorari.

Issue: Does a taxpayer hold property primarily for sale in the ordinary course of business if
such sale is of first and principal importance to the taxpayer?

Holding and Reasoning (Per curiam): Yes. Section 1221(1) of the Internal Revenue Code
states that proceeds from the sale of land are not entitled to capital gains treatment if the
land has been held primarily for sale in the ordinary course of business. Here, Riddell
argues that primarily means substantial. However, the term must be read according to its
ordinary, everyday usage. Reading the term literally, this Court holds that primarily means of
first importance or principally. Because the courts below applied a different and incorrect
interpretation of the term primarily, this Court remands the case to the District Court
for proceedings in accordance with this opinion. The judgment is vacated and remanded.
DEPRECIATIONS, Section 167-168 [NO CASES]

CHARACTERIZING GAINS, Hotchpotch Section 1231

Williams v. McGowan

Rule of Law: The sale of a business as a whole does not constitute the disposition of a
capital asset.

Facts: Williams (plaintiff) formed a hardware business with Reynolds in 1926. Williams had a
two-thirds interest in the company and Reynolds had a one-third interest. Williams and Reynolds
granted each other the privilege of purchasing each others interest in the business if and when
one of them withdrew. They ran the business together until Reynolds death in 1940. Williams
purchased Reynolds interest in the business from Reynolds executrix for $12,187.90. Later that
year, Williams sold the business for the value of the business in addition to $6,000. Around the
time of sale, the business value included about $8,100 in cash, $7,000 in receivables, $800 in
fixtures, and $49,000 in merchandise inventory, minus $1,000 for bills payable. The business
total value amounted to about $63,926.28. Williams sustained a loss upon the sale of his original
two-thirds interest and realized a small gain upon the sale of Reynolds one-third interest. He
reported both items as ordinary income rather than as capital assets. The Commissioner
disallowed treatment of the items as ordinary income. Williams paid income tax accordingly and
then brought suit to recover the amount overpaid. The trial court dismissed Williams complaint.

Issue: Does the sale of a business as a whole constitute the disposition of a capital asset?

Holding and Reasoning (Hand, J.)

No. It is well-established that a partners interest in a running business is a capital asset. There is
a question of whether a deceased partners interest in a business is also a capital asset, but this
court need not address that issue. When Williams purchased Reynolds interest, he became the
sole owner of the entire business. Thus, the tax treatment of Reynolds one-third interest upon
sale is irrelevant. The only issue to consider is whether, upon sale, the business must be broken
down to its component parts to determine whether each component constitutes a capital asset
under 117(a)(1), or whether the business is to be treated as one indivisible capital asset. Section
117(a)(1) defines all property as a capital asset, with three exceptions: (1) stock in trade or
inventory; (2) property held primarily to sell to customers; and (3) property used in a trade or
business that is of the type subject to depreciation deductions. Examining the language in this
provision, it is clear that Congress did not intend to treat an entire business as a single
indivisible unit. Congress instead contemplated the examination of each component of a
business to determine whether it falls within the definition of a capital asset as laid out in
117(a)(1). Here, Williams business can be broken down into cash, receivables, fixtures, and
inventory, each of which must be matched against the definition of a capital asset. There is
never a gain or loss upon transfer of cash and cash is not considered a capital asset.
Fixtures are subject to a depreciation allowance, and therefore are not capital assets. Any
gain or loss on the disposition of fixtures is an item of ordinary income. Inventory is
expressly excluded from the definition of a capital asset and is therefore also an item of
ordinary income. Although it does not seem that Williams realized a gain upon disposition of
the receivables, it has not been determined whether the receivables are of the type subject to
depreciation deductions. This is open for consideration in district court. The court holds that the
gain or loss realized upon the disposition of each of the other components of the business must
be treated as items of ordinary income. Accordingly, the judgment of the district court is
reversed.

Dissent (Frank, J.): Williams did not sell the company in separate bundles. He entered a contract
to sell the entire business as a whole. By reducing the singular sale of a company to several
separate sales of the companys component parts ignores the reality of what occurred. Congress
did not intend this type of result.
HOW MUCH INCOME IS OFFSET BY DEDUCTION?

Ordinary and Necessary Costs, Sec. 162

Welch v. Helvering

Rule of Law: Expenditures for ordinary and necessary business expenses may be deducted
from gross income if incurred while carrying on a trade or business.

Facts: E.L. Welch Company was a corporation involved in the grain business. Welch (plaintiff)
served as the secretary of the corporation before it went bankrupt and was discharged from its
debts. Welch was subsequently hired as a commission agent for Kellogg Company, a corporation
also in the grain business. In an effort to reconnect with old customers he had known through the
E.L. Welch Company, and to strengthen his credit and reputation, Welch substantially repaid
E.L. Welchs debts. On his tax return for those years, Welch deducted the amount of these
repayments as business expenses. The Commissioner determined that the repayments were not
necessary and ordinary expenses, but rather capital outlay for the purpose of developing his
reputation and good will. The Board of Tax Appeals held for the Commissioner. The Court of
Appeals affirmed.

Issue: May expenditures for ordinary and necessary business expenses be deducted from
gross income if incurred while carrying on a trade or business?

Holding and Reasoning (Cardozo, J.): Yes. Section 162 of the Tax Code states that expenses
for ordinary and necessary business expenses may be deducted from gross income if
incurred while carrying on a trade or business. Many payments may be deemed a necessary
expense, but not all necessary payments are ordinary. An expense does not need to be a regular
and recurring event in order to be ordinary. Even one-time payments can be ordinary. For
instance, if a company defends itself in a lawsuit by hiring an attorney, the attorneys fees is
probably an ordinary expense within the meaning of 162. But ultimately, whether an expense is
both necessary and ordinary is a determination based on the specific facts at hand. Here, the
Commissioner found that the repayment of debt was more akin to capital outlay than a necessary
and ordinary business expense. Taxpayers do from time to time pay off debts they are not legally
obligated to repay, deeming it necessary for the success of their business. However, such
payments are far from ordinary, even where such repayments prove beneficial. Welchs
repayment of his former corporations debt is not an ordinary business expense. Rather, it is
more akin to a capital outlay meant to build up his reputation and good will. Therefore, the
judgment of the Court of Appeals is affirmed.

Midland Empire Packing Co. v. Commissioner

Rule of Law: An expenditure is currently deductible as a repair to property if it is made

solely to keep the property in an ordinarily efficient operating condition.

Facts: Midland Empire Packing Co. (Midland) (plaintiff) was in business for about 25 years.
Midland used its basement to cure and store meats and hides. Occasionally, water seeped into the
basement rooms, but the water drained out and did not interfere with Midlands operations.
Eventually, however, oil from a nearby refinery began seeping into Midlands basement and
water wells. Unlike the water seepage, the oil did not drain out. It emitted a strong odor and the
fumes created a fire hazard. The Federal meat inspectors advised Midland that it must either stop
using the wells and oil-proof the basement, or shut down the plant. Accordingly, Midland oil-
proofed the basement by adding concrete lining to the walls and the floor. Midland then deducted
this expenditure as a necessary and ordinary business expense.

Issue: Is an expenditure currently deductible as a repair to property if it is made solely to

keep the property in an ordinarily efficient operating condition?

Holding and Reasoning (Arundell, J.): Yes. Expenditures to repair property are deductible as an
ordinary and necessary business expense. On the other hand, expenditures for capital outlay are
capitalized and deducted in installments over the capital assets useful life. In order to
determine whether expenditures are repairs or capital outlay, courts must look to the
purpose of the expenditure. If the expenditure is a replacement of the property in whole or
in part, or if it is an improvement intended to add to the propertys value, prolong its life,
or change its use, then it is a capital outlay. In American Bemberg Corporation, 10 T.C. 361
(1948), the Tax Court held that expenditures undertaken to prevent cave-ins of soil at a
manufacturing plant were deductible repairs because they were not intended to improve or
prolong the life of the property. Rather, the expenditures were made solely to allow the plant
to continue its operations on the same scale and level of efficiency and over the same period
of time as before the cave-ins became a threat. Similarly, Midlands expenditure was a repair
to its basement and not a capital outlay. Midland only made the expenditure in order to continue
its operations. The oil-proofing did not add value to or improve the basement in any way, nor did
it adapt the property to a new use. Furthermore, the oil-proofing did not prolong the life of the
property beyond what it was before the oil began seeping in. Although the oil-proofing did
prevent further seepage of water, the basement was not improved because the water never
interfered with Midlands operations. The repairs only served to allow Midland to use its
basement for the same purpose over its probable useful life. Therefore, the expenditure is
deductible as a repair. The Commissioner argues that although the expenditure was necessary, it
was not ordinary. However, the Supreme Court held in Welch v. Helvering, 290 U.S. 111 (1933),
that ordinary does not necessarily mean regular or frequent, and that even a one-time payment
can be ordinary if it is a common and accepted manner of dealing with a particular threat to a
business. Here, it is reasonable to deem oil-proofing as the ordinary course of action when the
property would otherwise be unusable. For these reasons, Midlands expenditure for the concrete
lining is deductible as an ordinary and necessary business expense.

Morton Frank v. Commissioner

Rule of Law: Expenses incurred while investigating and looking for a new business are not
deductible as ordinary and necessary business expenses.
Facts: Morton Frank and Agnes Dodds Frank (plaintiffs) were husband and wife. The Franks
were interested in purchasing and operating a newspaper or radio station. At the end of
November 1945, they left for a trip throughout the United States in an effort to find potential
newspapers or radio stations to purchase. In November 1946, they purchased a newspaper in
Ohio. Until they made the purchase, the Franks incurred significant travel, communication, and
legal expenses. The Franks deducted $5,965 of these expenditures as ordinary and necessary
business expenses.

Issue: Are expenses incurred while investigating and looking for a new business deductible
as ordinary and necessary business expenses?

Holding and Reasoning (Van Fossan, J.)

No. Section 23(a)(1) of the Internal Revenue Code allows deductions for expenses made in
carrying on a trade or business. Although the same provision also states that expenses made in
pursuit of a trade or business are deductible, pursuit refers to expenses related to or made in the
course of a trade or business. This suggests that there must be an existing trade or business.
Because the Franks did not have an existing business, their expenses were not related to the
conduct of business, as the statute requires. Rather, their travel, communication, and legal
expenses were preparatory to beginning a business venture. Therefore, the Franks are not entitled
to the claimed business expense deduction.
COMPENSATION, Sec. 162

Exacto Spring Corp. v. Commissioner

Rule of Law: Under federal tax law, a corporate salary is presumptively reasonable and
deductible as a business expense if the dividends are far higher than expected.

Facts: Exacto Spring Corp. (Exacto) (plaintiff) was a closely held corporation in the business of
manufacturing precision springs. Exacto paid one of its cofounders a salary of $1.3 million in
1993 and $1 million in 1994. This cofounder, in addition to being the principal owner of Exacto,
also operated as the chief executive officer, chief manufacturing executive, chief research and
development officer, and chief sales and marketing executive. Exactos investors received larger
dividends than anticipated during 1993 and 1994, expecting a 13 percent return but actually
receiving a return of more than 20 percent. Exacto deducted the cofounders salaries as business
expenses on its 1993 and 1994 federal tax returns. The commissioner of internal revenue
(commissioner) (defendant) determined that the salaries were too high and that a large portion
was actually a dividend taxable to Exacto. Exacto filed a petition challenging the commissioners
determination in the United States Tax Court. The tax court applied a seven-factor test and held
that a large portion of the salaries was reasonable, but that the remaining portion was still a
dividend. Exacto appealed.

Issue: Under federal tax law, is a corporate salary presumptively reasonable and
deductible as a business expense if the dividends are far higher than expected?

Holding and Reasoning (Posner, C.J.): Yes. A corporation may deduct reasonable salaries as
a business expense. Under the independent-investor analysis, a salary is presumptively
reasonable if the dividends returned to investors are far higher than expected. This is only a
presumption because scenarios exist in which a corporate executive is not being compensated for
his work, but rather is being given a dividend disguised as a salary. In this case, the tax court
applied a seven-factor test to determine whether the salary paid by Exacto should have been
considered a dividend. However, this seven-factor test is an inadequate measure, as many of the
factors contain duplicate analysis or do not directly prevent dividends from being disguised as
salary. Furthermore, this test leaves too much discretion for judges. No judge is adequately
equipped to determine whether the salary of a corporate executive is reasonable. The more
recent trend and proper test is the independent-investor analysis. Here, Exactos investors
expected a 13 percent return during 1993 and 1994, but actually received a more than 20
percent return. These dividends were far higher than expected. Thus, the salaries paid to
the cofounder were presumptively reasonable under the independent-investor analysis. The
evidence does not suggest that the cofounder was not being reasonably compensated for his
work, as he was running the company and operating in four executive roles. Because the
cofounders salaries were reasonable, Exacto may deduct the entire amount as a business
expense. Accordingly, the tax courts ruling is reversed.

Harolds Club v. Commissioner

United States Court of Appeals for the Ninth Circuit
340 F.2d 861 (1965)
Rule of Law: The entire amount paid under a contingent compensation agreement is
deductible, even if greater than what would ordinarily be paid, if it is paid pursuant to a
free bargain.

Facts: Raymond I. Smith (plaintiff) owned and operated an illegal gaming establishment in
California that later moved to Nevada. The gaming establishment was established in Nevada as
Harolds Club (Club). Smiths two sons wholly owned the Club. In 1935, Smith agreed to manage
the Club for a salary and bonus. In 1941, Smith and his sons decided to enter a fixed percentage
arrangement. Smith suggested that he should receive 20 percent of the profits, since Smith was
the brains of the organization. The sons agreed. From 19521956, Smiths salary ranged from
$350,000 to $560,000. The Club deducted this amount as a reasonable salary. The Commissioner
(defendant) determined that the Club could not deduct the full value of Smiths salary. At the
Tax Court, competing gaming establishments testified that Smiths salary was reasonable. The
Tax Court ruled in favor of the Commissioner.

Issue: Is the entire amount paid under a contingent compensation agreement deductible,
even if greater than what would ordinarily be paid, if it is paid pursuant to a free bargain?

Holding and Reasoning (Hamley, J.): Yes. Section 162(a)(1) of the Internal Revenue Code
allows business expense deductions for reasonable salaries. Corresponding Treasury
Regulations generally state that, where salaries are contingent on a companys net profits,
the entire amount is deductible even if greater than what would normally be paid. The only
conditions are that the employer and employee reach the contingent compensation
agreement through a free bargain and that the agreement is reasonable at the time it is
formed. Whether there is a free bargain is a fact-based determination, and any evidence
demonstrating the employers ability to exercise independent judgment is pertinent. Here, the
Club paid Smith according to a contingent compensation plan and claimed business expense
deductions for Smiths entire salary. Smiths salary was greater than what would ordinarily be
deductible under 162(a)(1). Nevertheless, the entire salary is deductible if made pursuant to a
free bargain. The Tax Court found that Smith and his sons did not reach the contingent
compensation agreement through a free bargain. It found that the family relationship between
Smith and his sons was one in which Smith exercised domination and control over his sons. This
court agrees. Although the sons were two competent adults, their family relationship with Smith
suggests that the agreement could not be the result of a free bargain. The Club argues that the
sons agreed to the salary plan in recognition of Smiths true worth to the organization. But this
argument is contrary to evidence indicating that the sons agreed to the salary because Smith was
the brains behind the organization, not because his services were indispensible. The Club notes
that the Commissioner previously found Smiths salaries from 19411949 to be reasonable. The
Club argues that if the salary was reasonable when the sons were younger and more easily
dominated by their father, the salary should still be reasonable from 19521956, when the sons
were older. But the Commissioner did not consider the issue before this court today, which is
whether the compensation agreement was the result of a free bargain. Therefore, the
Commissioners previous rulings are inapplicable here. This court finds that the agreement was
not made pursuant to a free bargain and that the salary is not reasonable under 162(a)(1).
Therefore, a deduction for Smiths entire salary is disallowed. The Club argues that if it cannot
deduct Smiths salary as a business expense, the salary would be double-taxed. Smith would pay
an income tax on the sum while the Club would pay a corporate tax. Regardless of whether
Smiths salary might be double-taxed, 162(a)(1) clearly states that only reasonable salaries are
deductible. The Clubs interpretation of the statute entirely omits the reasonable requirement,
arguing that deductions should only be disallowed if the Club is disguising forms of income as
salary. But 162(a)(1) applies a reasonableness requirement regardless of whether income is
disguised as salary. The Club further argues that this courts interpretation of the Internal
Revenue Code transforms the Code into a regulatory provision that controls salaries. It is true
that the Code regulates businesses in that it dissuades them from disguising dividends or other
income as salaries to employees. But this regulatory effect is only incident to the Tax Code, and
not its primary purpose. For the foregoing reasons, the judgment of the Tax Court is affirmed.
TRAVEL EXPENSES

Rosenspan v. United States

Rule of Law: In order to deduct traveling expenses incurred in connection with a business,
the taxpayer must maintain a place of residence.

Facts: Robert Rosenspan (plaintiff) was a traveling jewelry salesman. In 1962 and 1964, he was
employed by New York City jewelers. He traveled throughout the Midwest 300 days a year and
did not maintain a permanent residence. Rosenspan sought to deduct his expenses for meals and
lodging while traveling. The Commissioner (defendant) disallowed the deduction. Rosenspan
sued for a refund in the District Court for the Eastern District of New York. The District Court
dismissed the complaint.

Issue: Can a taxpayer who does not maintain a place of residence deduct travel expenses
incurred in connection with a business?

Holding and Reasoning (Friendly, J.): No. Section 162(a)(2) of the Internal Revenue Code
allows deductions for ordinary and necessary traveling expenses incurred while away from home
in the pursuit of a trade or business. An earlier version of 162 only allowed deductions for the
amount in excess of what a taxpayer would normally spend at home. This version required a
complicated calculation of a taxpayers ordinary expenditures. Also, under this version, a
taxpayer without a home was not eligible to deduct traveling expenses from his income. In 1921,
Congress amended the statute to its current version, allowing the deduction of the full amount of
meals and lodging expenses. Thus, the current version of 162(a)(2) no longer requires the
calculation of a taxpayers ordinary expenses. In amending the statute in this regard, Congress
gave no indication that it meant to also amend the statute to allow a traveler without a home to
take a deduction. It merely meant to simplify the application of 162(a)(2) by no longer
requiring a complicated calculation. Ultimately, the question of whether a traveler without a
home may claim a deduction is resolved by the plain language of the statute. A taxpayer cannot
be away from home unless the taxpayer has a home. Therefore, a taxpayer without a home is
not eligible to take a deduction under 162(a)(2). Rosenspan argues that for the purposes of
162(a)(2), a taxpayers home is his business headquarters. Supreme Court cases have not
resolved whether a taxpayers home is in fact his business headquarters or his place of residence.
In Commissioner v. Flowers (1946), Flowers maintained his residence in Mississippi but worked
for a company in Alabama. Flowers claimed deductions for his transportation, meals, and
lodging. The Court held that Flowers could only be eligible for the deduction on three
conditions. First, the traveling expense must be reasonable and necessary. Second, the
expense must be made while away from home. Third, there must be a direct connection
between the expenditure and the business pursued, and the expenditure must be necessary
or beneficial to the pursuit of the business. Flowers employer gained nothing from Flowers
decision to live in Mississippi and travel extensively to Alabama. Thus, the Court held that
Flowers travels failed to meet the third requirement, which required the travel to bestow some
benefit to the business, and Flowers was ineligible to take the deduction. In Peurifoy v.
Commissioner, 358 U.S. 59 (1958), the Court upheld the ruling in Flowers that travel expenses
should only be deducted when necessary for business operations. In Commissioner v. Stidger,
386 U.S. 287 (1967), the Court held that a Marine could not deduct expenses while stationed in
Japan, in part because Congress does not allow travel and transportation allowances for military
personnel. In each of these cases, the Court declined to rule on whether the place of business or
the place of residence is a taxpayers home for the purpose of 162(a)(1). The Commissioner in
each of these cases argued that a taxpayers place of business was his home under 162(a)(1).
But the Commissioner did not prevail on that basis. Instead, the Commissioner prevailed on the
basis that the taxpayers travels were not sufficiently beneficial to their respective businesses.
The Commissioner does not need his interpretation of 162(a)(1) in order to prevail in a great
deal of similar cases. Thus, the Commissioner should not be adversely affected by this courts
reliance on the ordinary meaning of the term home in holding that 162(a)(1) refers to a place
of residence. The resolution of Rosenspans case rests on the fact that Rosenspan had no home to
be away from during his travels. Because Rosenspan does not satisfy the second condition under
Flowers, the judgment dismissing Rosenspans complaint is affirmed.
EDUCATION AND ENTERTAINMENT

Hill v. Commissioner

Rule of Law: Ordinary and necessary education expenses incurred while carrying on a
trade or business are deductible.

Facts: Nora Payne Hill (plaintiff) was a high school teacher in Virginia. Virginia law required
that all teachers hold teaching certificates. Teachers were required to renew their certificates
periodically. Part of the renewal process involved a choice between taking college courses and
passing an exam covering five selected books. Hill chose to attend summer courses at Columbia
University. She incurred expenses of $239.50. On her tax return for that year, Hill claimed a
business deduction for her summer school expenditures. The Commissioner (defendant) deemed
the expenditures to be personal in nature and disallowed the deduction. The Tax Court affirmed
the disallowance.

Issue: Are ordinary and necessary education expense incurred while carrying on a trade or
business deductible?

Holding and Reasoning (Dobie, J.): Yes. A taxpayer may deduct business expenses if the
expenses are: (1) incurred within the taxable year in question; (2) incurred in order to carry on a
trade or business; and (3) ordinary and necessary. Furthermore, the expenses must not be
personal in nature. An ordinary expense is not necessarily habitual or frequent. Even a one-time
expense is ordinary for the purpose of a business deduction as long as it is normal for the type of
business in question. The Tax Court below held that Hills expenses were not deductible in part
because teachers did not ordinarily attend school to renew their certificates when other options
were present. But Hill is not required to present statistics demonstrating that many teachers
choose to attend a college course rather than take the exam. Hills expenses for the summer
school course are ordinary as long as they are a reasonable method of renewing her certificate.
The Tax Court also said Hills expenses were not deductible because she did not affirmatively
demonstrate that she was employed when she took the summer school courses. Thus, the Tax
Court reasoned, Hills expenses may have been incurred while seeking reemployment rather than
while carrying on a trade or business. However, it is sufficient that Hill demonstrated she had
been a teacher for decades and that there was no evidence her employment had been terminated.
Hill did not gain any advantage or new position from taking the course. She merely maintained
her current position. Thus, the expenses for the course were not personal in nature. In light of the
above, Hills expenditure satisfies the requirements of a business tax deduction. The judgment of
the Tax Court is reversed and the case is remanded.

Coughlin v. Commissioner

Rule of Law: Educational expenses incurred in the discharge of a taxpayers professional

duties are deductible.

Facts: Coughlin (plaintiff) was an attorney in a New York firm. The nature of the firms work
required that at least one of the firms lawyers be skilled in federal taxation. The firm depended
on Coughlin to fulfill this obligation, which included the duty to keep himself regularly apprised
of any developments in the field. In furtherance of this obligation, Coughlin attended a
conference on federal taxation, incurring $305 in expenses. He claimed this amount as an
ordinary and necessary business expense. The Commissioner (defendant) and the Tax Court
disallowed the deduction, ruling that the expense was both educational and personal.

Issue: Are educational expenses incurred in the discharge of a taxpayers professional

duties deductible?

Holding and Reasoning (Chase, J.): Yes. An educational expense is deductible if it is ordinary
and necessary, and directly connected to the taxpayers profession. An expense is ordinary if
professionals in the same field incur such expenses. An expense is necessary if it is appropriate
and helpful. In Welch v. Helvering, 290 U.S. 111 (1933), the Supreme Court said in dictum that
the cost of learning is a non-deductible personal expense. But the Court there primarily referred
to learning intended for cultural edification or for use in future business endeavors. In contrast,
ordinary and necessary educational expenses incurred in the course of ones profession are
deductible. In Hill v. Commissioner, 181 F. 2d 906 (1950), a teacher who was required to take a
summer school course in order to retain her job was allowed to deduct the expense of the course.
Coughlins situation is similar. To be sure, there is no evidence that he would have lost his job if
he did not attend the conference. But he was nonetheless obligated and depended upon to keep
himself apprised of developments in the tax field. He chose to fulfill this obligation by attending
the conference. Coughlin may have incidentally gained personal edification through the
experience. But because his primary reason for attending the conference was to discharge his
professional obligations, the expense was not personal in nature. Furthermore, the expense for
the conference cannot be considered a capital expenditure. The benefit derived from the
conference is too fleeting to be regarded as a capital expenditure. Therefore, Coughlin is entitled
to deduct the cost of the conference as a necessary and ordinary business expense. The decision
of the Tax Court is reversed and remanded.
BUSINESS LOSSES & BAD DEBTS, Sec. 165

Bugbee v. Commissioner

Rule of Law: Under federal tax law, a taxpayer may deduct the amount of a bona fide loan
that has become worthless.

Facts: Howard Bugbee (plaintiff) owned a bar, where he first met Paul Billings in 1957. Bugbee
and his wife were not wealthy and lived off moderate means. Over the next few years, Bugbee
and Billings became friends, and Billings became the godfather to one of Bugbees children.
Even though Billings was unemployed, Bugbee believed that Billings had some good business
ideas and decided to loan him money. Billings did not pay interest on the first few loans, but
Bugbee continued to loan more money to Billings. From 1958 to 1960, Bugbee lent Billings a
total of $19,750 through 11 formal, unsecured notes with at least 6 percent interest. Bugbee
expected to be repaid once one of Billingss business ventures was successful, but Billings was
obligated to repay Bugbee regardless of success. However, Billings did not repay any of the
principal or interest. Bugbee deducted the loans to Billings as a personal bad debt on his federal
tax return. The commissioner of internal revenue (commissioner) (defendant) disallowed the
deduction. Bugbee filed a petition challenging the commissioners disallowance.

Issue: Under federal tax law, may a taxpayer deduct the amount of a bona fide loan that
has become worthless?

Holding and Reasoning (Sterrett, J.): Yes. A taxpayer may deduct the amount of a bona fide loan
as a personal bad debt if the loan has become worthless. Payment contingent on a business
outcome is not a bona fide loan. A loan between friends is often qualified as a gift rather than a
bona fide loan, depending on whether the lender expected repayment. In this case, Bugbee made
a bona fide loan to Billings. Although Bugbee could not have reasonably expected to collect an
unsecured debt from Billings, who was a poor financial candidate, these debts were not
worthless. Every unsecured debt contains a risk that the lender willingly accepts. Additionally,
Billingss repayment was not contingent on his business success, and Billings was obligated to
pay with whatever funds he might have. Finally, Bugbee and Billings were personal friends.
However, the money could not be qualified as a gift, because Bugbees finances did not indicate
that he had the financial freedom to distribute the significant loans to Billings without the
expectation of repayment. For these reasons, Bugbee is entitled to deduct the loans to Billings
as personal bad debts. Accordingly, judgment is entered for Bugbee.

Charles J. Haslam v. Commissioner

Rule of Law: A taxpayer is entitled to deduct a loss from the guarantee of a bad debt to a
wholly owned corporation from ordinary income if the taxpayers dominant motivation is
to protect his employee interest in the corporation.

Facts: In 1954, Charles J. Haslam (plaintiff) and Earl Canavan formed Northern Explosives, Inc.
(Northern), a corporation specializing in the sale and distribution of explosives. Haslam had
previously gained experience with explosives through the army, school, and prior jobs. In 1957,
Haslam became the sole owner of Northern, having invested a total of $20,000. In 1960,
Northern had financial troubles and required a loan to continue its operations. Haslam therefore
guaranteed a loan to Northern by the National Commercial Bank and Trust Company of Albany,
New York (National) in the amount of $100,000. The loan was secured by some of Haslams
securities and his personal residence. Northern went bankrupt in 1964. Because Northern was
unable to repay the loan to National, National sold some of Haslams securities, resulting in the
repayment of $55,956 of Northerns debt. Until Northern went bankrupt, Haslam was employed
full-time by Northern and earned approximately $15,000 annually. Haslams income came
primarily from his employment with Northern. After Northern went bankrupt, Haslam obtained
employment in an unrelated field for a smaller salary, as skills in explosives were not marketable
at the time. On his tax return for 1967, Haslam claimed a business bad debt in the amount of
$55,956. The Commissioner (defendant) ruled that Haslam could only claim the amount as a
nonbusiness bad debt.

Issue: Is a taxpayer entitled to deduct a loss from the guarantee of a bad debt to a wholly
owned corporation from ordinary income if the taxpayers dominant motivation is to
protect his employee interest in the corporation?

Holding and Reasoning (Forrester, J.): Yes. Section 166 of the Internal Revenue Code allows
a taxpayer to deduct losses from the guarantee of bad debts. Business bad debts are
deducted from ordinary income, whereas nonbusiness bad debts are deducted as short-
term capital losses. Whether a bad debt is business or nonbusiness depends on the relationship
between the guarantee of the debt and the taxpayers trade or business. Guarantees made
merely to protect a taxpayers interest in a corporation as an investor are not deductible as
business bad debts. The guarantee must be proximately related to the taxpayers trade or
business as an employee. Where a taxpayer has an interest as both an employee and a
stockholder, the taxpayer must demonstrate that the dominant motive behind the
guarantee was to protect the taxpayers interest as an employee. In United States v. Generes,
405 U.S. 93 (1972), a taxpayer was both an employee and shareholder of a corporation. He had
invested $40,000 in his corporation. He worked six to eight hours weekly for an annual salary of
$12,000. He worked full-time at another corporation, where he earned a salary of $19,000. A few
of his family members also had employment and investment interests in the corporation. The
Supreme Court held that the facts did not demonstrate the taxpayers dominant motive in
guaranteeing a loan to the corporation was to protect his employee interest. Here, the guarantee
undertaken by Haslam is clearly related to his trade or business as an employee. However,
because Haslam is both an employee and investor of the corporation, Haslam must demonstrate
that his dominant motive was to protect his employee interest. Haslams case is unlike that in
Generes. Haslam was employed full-time by Northern. He was not employed anywhere else and
his salary from Northern was his main source of income. His skills were not marketable outside
of Northern, as evidenced by the fact that he took a job in an unrelated field for a smaller salary
after Northern went bankrupt. These facts demonstrate that Haslams dominant motive
behind guaranteeing the loan was to preserve his employment rather than to protect his
investment. Haslam stood to lose $20,000 as an investor, but stood to lose $15,000 annually
as an employee. His employment with Northern was worth much more than his investment
and was therefore his dominant motive for guaranteeing the loan. Accordingly, the loss is
deductible as a business bad debt.

Whipple v. Commissioner

Rule of Law: For federal tax purposes, a taxpayer may deduct bad business debts only if
the taxpayer is carrying on a related trade or business.

Facts: A. J. Whipple (plaintiff) was the 80 percent owner of Mission Orange Bottling Company
of Lubbock, Inc. (Mission Orange). Whipple bought land, built a factory on the land, and leased
the premises to Mission Orange. Mission Orange did not pay Whipple a salary, and Whipple had
no employment duties. Whipple also loaned Mission Orange significant money for other
expenses. In 1953, Whipples loans and lease agreement with Mission Orange became worthless.
Whipple deducted these amounts on his federal taxes as a bad business debt. The commissioner
of internal revenue (commissioner) (defendant) determined that this was a nonbusiness bad debt
and assessed a deficiency. Whipple petitioned the tax court for a redetermination. The tax court
found for the commissioner, holding that Whipple was not in the business of bottling or general
financing. The court of appeals affirmed. The United States Supreme Court granted certiorari.

Issue: For federal tax purposes, may a taxpayer deduct bad business debts only if the
taxpayer is carrying on a related trade or business?

Holding and Reasoning (White, J.): Yes. A taxpayer may deduct worthless bad business debts
only if he is carrying on a trade or business related to those debts. If the taxpayer is merely
acting as an investor and does not provide employment services, he is not entitled to deduct
any loss as a bad business debt. Here, Whipple was merely acting as an investor in Mission
Orange in the business of bottling or general financing, as none of his income was derived from
providing employment services. All of Mission Oranges payments to Whipple were for either
rent or the repayment of loans. These payments did not result from Whipples provision of
services, but rather from the corporations business itself. However, even though Whipple was
not in the business of bottling or general financing, some of Whipples debt could have been
related to his trade or business as a landowner. Therefore, because the lower courts did not make
this determination, the judgment is vacated and remanded to the tax court.
Income-Producing Expenses

Commissioner v. Tellier

Rule of Law: Courts may not disallow deductions otherwise allowable under section 162 of
the Internal Revenue Code on public policy grounds for legal expenses incurred in defense
of criminal charges.

Facts: In 1956, Walter F. Tellier (plaintiff) was indicted on 36 counts of fraud and conspiracy
related to his business underwriting stock offerings and purchasing securities for resale. He was
convicted on all counts. Tellier spent $22,964.20 in legal expenses incurred for his defense. He
deducted this amount as an ordinary and necessary business expense. The Commissioner
(defendant) disallowed the deduction. The Tax Court sustained the Commissioners
disallowance. The Court of Appeals reversed. The United States Supreme Court granted
certiorari.

Issue: May courts disallow deductions otherwise allowable under section 162 of the
Internal Revenue Code on public policy grounds for legal expenses incurred in defense of
criminal charges?

Holding and Reasoning (Stewart, J.): No. Section 162 of the Internal Revenue Code requires that
an expenditure be incurred in carrying on a business. The origin and character of the claim that
leads to the expense determines whether an expense is personal or business in nature. Section
162 also requires that an expenditure be both necessary and ordinary. An expenditure is
necessary if it is appropriate and helpful. An expenditure is ordinary if it is currently deductible
and not incurred to procure a capital asset. Here, Tellier meets all the requirements of section
162. His legal expenses were incurred in defense of charges stemming from his business
activities. Thus, the expense was business in nature, not personal. Furthermore, there is no
dispute that the expenditure was both necessary and ordinary, particularly because he did not
incur the expense in procuring a capital asset. Therefore, Tellier is entitled to a deduction for his
legal fees under section 162. The Commissioner does not dispute this. Instead, the Commissioner
argues that the deduction must be disallowed on public policy grounds. This Court disagrees.
Congress has made clear that our system of federal income tax is not intended to punish
wrongdoing. It is only intended to tax the net income of every individual. The same principle
extends to tax deductions. Congress does not require that a taxpayer demonstrate his trade or
business is legitimate or lawful before he is entitled to deductions. For this reason, in
Commissioner v. Sullivan, 356 U.S. 27 (1958), this Court allowed a deduction of rent and wages
even where the expenses were illegal. Similarly, in Lilly v. Commissioner, 343 U.S. 90 (1952),
this Court allowed deductions for unethical payments made by opticians. Finally, in
Commissioner v. Heininger, 320 U.S. 467 (1943), this Court allowed deductions for lawyers
fees incurred to defend against an accusation of fraud. These cases make clear that the illegality
of Telliers business activities does not prevent him from taking a deduction for business
expenses otherwise allowable by section 162. To be sure, Congress has the power to disallow
deductions for expenses incurred in certain types of activities. But where Congress has not
explicitly done so through legislation, this Court will not disallow otherwise valid deductions
unless the allowance will sharply frustrate national or state polices that proscribe such conduct.
For instance, in Hoover Express Co. v. United States (1958), this Court disallowed a deduction
that otherwise would have been allowable. There, the taxpayers had been fined for violating a
state statute. Allowing a deduction for the payment of a fine would serve to decrease the penalty,
thereby frustrating the states intention of punishing the taxpayer to a certain degree. Here, in
contrast, there is no suggestion that national or state policy requires the disallowance of the
deduction. Telliers use of a lawyer to defend himself does not offend public policy. Rather, it is
his constitutional right to incur legal expenses for his defense. Congress has already imposed
punishment on Tellier for his illegal activities. There is no reason for this Court to punish Tellier
beyond what Congress has set out by disallowing the deduction at issue. For the foregoing
reasons, the judgment of the Court of Appeals is affirmed.

Higgins v. Commissioner

Rule of Law: Under 23(a) of the Internal Revenue Code, personal investment activities do
not constitute carrying on a trade or business.

Facts: Higgins (plaintiff) had substantial holdings in both real estate and securities. He set up
offices in New York and Paris and hired employees dedicated to overseeing his investments. His
staff handled the day-to-day responsibilities related to the investments under Higgins close
supervision. Their responsibilities included keeping records and collecting interest and
dividends. Higgins relied on these offices in this manner for over thirty years. In 1932 and 1933,
Higgins deducted the salaries of his employees and other expenditures related to his two offices
as ordinary and necessary business expenses. The Commissioner (defendant) disallowed the
deductions on the grounds that personal investment activities did not constitute the carrying on of
a business. However, the Commissioner conceded to the Board of Tax Appeals that Higgins real
estate activities constituted a business. The Board of Tax Appeals held that insofar as the
expenditures related to Higgins real estate, the expenditures were deductible. The activities
related to his securities, on the other hand, did not constitute the carrying on of a business and
were non-deductible. Accordingly, the Board of Tax Appeals ordered the apportionment of
Higgins expenses between his real estate and securities operations. The Court of Appeals
affirmed. The Supreme Court granted certiorari.

Issue: Under 23(a) of the Internal Revenue Code, do personal investment activities
constitute carrying on a trade or business?

Holding and Reasoning (Reed, J.): No. There is no statutory guidance or regulation that
interprets the phrase carrying on a business. Thus, the issue of whether an activity constitutes
the carrying on of a trade or business is a factual determination. Here, Higgins offices existed
solely to handle his personal investment activities. In that regard, the offices activities do not
constitute the carrying on of a trade or business. Higgins relies on cases that have disallowed
deductions for personal investments where the taxpayers activities were sporadic. He argues
that because he continuously carried on his investment activities for over thirty years, his
case is distinct from that of a small investor who only occasionally conducts such activities.
But however extensively he may have carried on these activities, they do not constitute
carrying on a trade or business. Therefore, the judgment of the Court of Appeals is
affirmed.
Surasky v. United States

Rule of Law: Ordinary and necessary non-business expenses incurred for the production of
income are deductible from gross income.

Facts: Surasky (plaintiff) purchased 4,000 shares of Montgomery Ward & Co. at the advice of
Louis E. Wolfson, a substantial shareholder in the company. Wolfson developed an elaborate
plan that he believed would improve the company and result in an increase in its stock value. The
plan included such objectives as electing a new board of directors, introducing new management,
and ultimately achieving an increase in dividends. Wolfson, together with Surasky and other
stockholders, established a committee to implement the plan. In 1955, Surasky contributed
$17,000 to the committee in the hopes of generating more income from his investment. The
committee managed to achieve some of its stated goals. Three of the nine board members were
replaced and two original members of management resigned. Furthermore, the company enjoyed
an increase in dividends in the latter half of the year. Surasky deducted the $17,000 expenditure
as an ordinary and necessary non-business expense. The district court ruled that Surasky was not
entitled to the deduction.

Issue: Are ordinary and necessary non-business expenses incurred for the production of
income deductible from gross income?

Holding and Reasoning (Tuttle, C.J.): Yes. Section 212 of the Internal Revenue Code allows
deductions for ordinary and necessary non-business expenses incurred for the production
of income. The district court held that Suraskys expenditure was not deductible because it was
far too speculative to form a direct and proximate connection to the production of income. In
doing so, the district court too stringently required the showing of a proximate relationship
between the expenditure and the desired production of income. While a reasonable connection
between the expenditure and the income produced is necessary, a taxpayer need not satisfy the
common law definition of proximate cause. It is sufficient that the taxpayer exercise
reasonable business judgment in making the expenditure. Here, Surasky clearly made the
$17,000 payment in order to increase the production of income from his investment.
Although there was a chance of failure, there was also a reasonable likelihood of success,
and the positive results enjoyed by the committee and Surasky only confirm that Surasky
exercised reasonable business judgment in making the expenditure. The district court erred
in holding that the connection between Suraskys expenditure and the resulting production of
income was insufficient. The judgment of the district court is therefore reversed and the case is
remanded to the district court for entry of judgment in Suraskys favor.

Meyer J. Fleischman v. Commissioner

Rule of Law: Legal expenses are deductible if they are incurred while defending against
claims arising in connection to a profit-seeking activity.

Facts: On February 22, 1955, Meyer J. Fleishman and Joan Ruth Francis entered an antenuptial
agreement. The agreement stipulated that in the event of a divorce, Meyer would pay Joan
$5,000, who in turn would release all her rights to Meyers property. In 1961, Joan initiated
divorce proceedings. In contravention of the prenuptial agreement, she sued for fair and
equitable division of all property. However, the court overseeing the divorce proceedings lacked
authority to invalidate the antenuptial agreement. Thus, in a separate action, Joan sued to set
aside the antenuptial agreement. The divorce was finalized in 1962 and Joans suit to set aside
the antenuptial agreement was dismissed. Meyer incurred $3,000 in legal fees defending the
lawsuit to invalidate the antenuptial agreement. He deducted the fees as an ordinary and
necessary non-business expense. The Commissioner (defendant) disallowed the deduction.

Issue: Are legal expenses deductible if they are incurred while defending against claims
arising in connection to a profit-seeking activity?

Holding and Reasoning (Simpson, J.): Yes. Section 212 of the Internal Revenue Code allows
deductions for ordinary and necessary non-business expenses incurred in three
enumerated contexts. Section 212(1) allows such deductions when incurred for the
production of income. Section 212(2), in pertinent part, allows such deductions when
incurred for the conservation of income. Section 212(3) allows for such expenses when
incurred for the acquisition of tax advice. Notwithstanding these provisions, personal legal
expenses are non-deductible. Here, Meyer relies on Carpenter v. United States (1964), in which
the court allowed deductions under 212(3) for legal expenses incurred to obtain tax counsel
during a divorce proceeding. But 212(3) is inapplicable to Meyer because he did not incur the
legal fees at issue to obtain tax advice. Section 212(1) is also inapplicable because there is no
evidence that Meyer incurred the legal expenses in order to produce income. Thus, Meyer can
only prevail if he can prove he incurred the legal expenses for the conservation of income under
212(2). In United States v. Gilmore(1963), a taxpayer owned the controlling interest in three
corporations. His income derived primarily from these corporations. During his divorce
proceedings, his wife sought over half of his holdings in the corporations. He incurred significant
legal expenses defending against his wifes claims, which he attempted to deduct under 212(2)
as an expense incurred for the conservation of income. Looking to the origin and nature of the
claim giving rise to the taxpayers legal expenses, the Court ruled they were non-deductible
because they were personal in nature. Deductions are allowable under 212(2) only if the claim
giving rise to legal expenses arises in connection with a profit-seeking activity. If the claim arises
in connection with a personal matter, such as a marital relationship, any expenses incurred in
defending against that claim are also personal and therefore non-deductible. In other words, if a
claim would not exist but for a marital relationship, the legal fees incurred in defending against
that claim are non-deductible. Here, Joan sought to set aside an antenuptial agreement on the
grounds that, as Meyers wife, she was entitled to more property. Her claim arose solely out of
her marital relationship with Meyer. But for her marriage to Meyer, she would have no claim.
Consequently, the claim is a personal one, and Meyers legal expenses incurred in defending
against the claim are also personal and therefore non-deductible. Meyer argues that his case is
distinct from Gilmore because Joans claim to his property arose in a suit separate from the
divorce proceedings, and therefore did not arise in connection with his marital relationship.
However, the claim arose in a separate suit only because the court handling the divorce lacked
jurisdiction to rule on the validity of the antenuptial agreement. Joan ultimately filed the separate
suit to obtain support payments due to her as a result of her marriage to Meyer. Therefore,
Meyers legal expenses are non-deductible.
Lowry v. United States

Rule of Law: A taxpayer need not make a bona fide offer to rent in order to convert a
personal residence into income producing property.

Facts: Edward G. Lowry, Jr. (plaintiff) was the de facto owner of a summer home located in
Marthas Vineyard. The home was part of a community run by the Seven Gates Farm
Corporation, which held legal title to the property. In 1967, Lowry decided he no longer needed
the summer home. He immediately put the property up for sale. Lowry, who had extensive
experience in real estate transactions, recognized that home prices in Marthas Vineyard were on
the verge of a rapid increase. Although the home had a fair market value of $50,000 in 1967,
Lowry listed the property for $150,000. Until the property was sold, Lowry returned each spring
to open the home and maintain the property. He came back each fall to close the home for the
winter. He only slept in the home when he stayed to maintain the property. He also used the
home once a year to host the Seven Gates Farm Corporations annual shareholders meeting.
Lowry never used the property as a personal residence after he listed it on the market. He did not
attempt to rent the house because he believed that a clean home would sell faster, and that
furnishing the home for rental would be financially unviable. Furthermore, the Seven Gates Farm
Corporation had placed considerable restrictions on renting the home. The property sold in 1973
for $150,000. In 1970, Lowry deducted the expenses for the care and maintenance of the home
on the grounds that he no longer used the summer home as his personal residence. The
Commissioner disallowed the deduction and assessed a corresponding tax against Lowry. Lowry
paid the tax under protest and brought suit in United States District Court to recover the
payment.

Issue: Must a taxpayer make a bona fide offer to rent in order to convert a personal
residence into income producing property?

Holding and Reasoning (Bownes, J.): No. Taxpayers may not deduct ordinary and necessary
expenses incurred for the maintenance of personal property. They may, however, deduct
such expenses when incurred for the maintenance of income producing property. A
taxpayer who seeks to deduct maintenance expenses for property previously held as a personal
residence must demonstrate conversion of the property into income producing property. The Tax
Court once held that a taxpayer must make a bona fide offer to rent in order to convert a personal
residence into income producing property. In Hulet P. Smith v. Commissioner, 26 T.C.M. 149
(1967), the Tax Court rejected the rental test and only required an offer for sale together with an
abandonment of the property. In Frank A. Newcombe v. Commissioner, 54 T.C. 1298 (1970),
however, the Tax Court abandoned both tests. Instead, the court stated that the primary question
was whether the taxpayer intended an expectation of profit. The court set forth a list of factors
relevant to this question, such as the length of time the taxpayer lived in the property before
abandonment, whether the taxpayer used the home personally while it was unoccupied, the
recreational nature of the property, any attempts to rent the property, and whether the taxpayer
made the offer to sell in an attempt to realize post conversion appreciation. If a taxpayers true
intent is to take advantage of post-conversion appreciation and thereby maximize capital gain,
the taxpayer has sufficiently converted a personal residence into income producing property.
Evidence that the taxpayer immediately listed the property for sale tends to negate a taxpayers
intent to realize post-conversion appreciation. This court adopts the Newcombe test. Here, the
facts indicate that Lowry intended an expectation of profit because his true intent was to realize
post-conversion appreciation. Lowry, who was well-familiar with the housing market in the
1960s and 1970s, was aware that property values in Marthas Vineyard were about to rise
dramatically. For this reason, he listed the property for $150,000 when it was only worth $50,000
at the time. Lowry believed that by keeping the property visible on the market and well-
maintained, the home would eventually sell at his listed price. His refusal to rent the property
while he waited does not negate his intent to realize income, since he had sound financial reasons
for avoiding rental. Furthermore, the fact that Lowry immediately placed the property on sale
after abandoning the property does not negate his principal intent. He immediately listed the
property in order to keep it visible on the market and thereby make it more profitable at the time
of sale. As a result of his efforts, Lowry realized over $100,000 in capital gain from the sale of
the home. These facts demonstrate that Lowry possessed a reasonable expectation of profit. This
intent converted his personal residence into an income producing property. Lowry is therefore
entitled to deduct the expenses incurred for maintenance of the property.

Engdahl v. Commissioner
Tax Court of the United States
72 T.C. 659 (1979)

Rule of Law

An individual can deduct losses resulting from an activity if the individual is engaged in the
activity for profit.

Facts

After Dr. Engdahl retired, he and his wife (plaintiffs) looked for a way to supplement his
retirement income. They asked veterinarians, a horse trainer, and other horse breeders about the
business of horse breeding and decided to start breeding horses. The Engdahls kept complete
financial records of their horse operations. They deposited any income derived from horse
breeding into a separate savings account. Their accountant reviewed their horse breeding ledgers
and created a financial summary each quarter. After three years, the Engdahls sold their house
and bought a ranch so they could house their horses on site as opposed to at a stable. The
Engdahls spent 35 to 55 hours per week maintaining the horses and ranch. They did not ride the
horses themselves and stated they had no emotional attachment to the horses. If a horse did not
live up to the Engdahls show or breeding standards, they would get rid of it. The Engdahls
ranch and horses appreciated in value after the purchases. However, the Engdahls lost money on
their horse operations every year. The Engdahls deducted these losses on their tax returns. The
IRS disallowed the deductions. The Engdahls filed a petition for review in tax court.

Issue

Can an individual deduct losses resulting from an activity if the individual is engaged in the
activity for profit?
Holding and Reasoning (Hall, J.)

Yes. An individual can deduct losses resulting from an activity if the individual is engaged in the
activity for profit. There are several factors courts should use to determine whether an activity is
for profit: (1) the manner in which the individual engaged in the activity, including the presence
or absence of recordkeeping, the similarity of the activitys operations to operations of for-profit
businesses, and whether the individual made any changes to the operations to increase
profitability; (2) the expertise of the individual or his adviser in the activity; (3) the time and
effort the individual spends on the activity; (4) any expectation that activity assets will increase
in value; (5) the individuals success in engaging in other activities; (6) the individuals profit or
loss history with respect to the activity; (7) any occasional profit earned; (8) the individuals
financial status; and (9) whether the individual engages in the activity at all for leisure. In this
case, the Engdahls engaged in horse breeding for profit. Accordingly, the deductions of their
horse-breeding losses were appropriate. First, the manner in which the Engdahls engaged in their
horse operations is indicative that they bred horses for profit. The Engdahls kept financial
records of the operations and ensured that an accountant reviewed the records. They also kept
horse-related income separate. In addition, after three years in the business, they bought a ranch
to expand their operations and reduce operational costs, thereby increasing profitability. Second,
the Engdahls consulted several experts on the profitability of the business before entering the
business themselves. This also indicates intent to make a profit. Third, although the Engdahls
never actually made a profit, it is not uncommon for businesses in early stages to be unable to
turn a profit. Thus, the Engdahls losses do not necessarily mean that they had no intent to make
a profit. Finally, the evidence of the Engdahls hard work on the ranch supports their contention
that they gained no personal pleasure from horse breeding. Overall, these factors point to the
Engdahls intent to make a profit from horse breeding. They are thus entitled to deduct their
horse-breeding losses.