Review

Timing Issues
Basis
Measure total gain or loss
Recover cost once and only once

Annual Accounting
Measure results by years, not
transactions
NOL / IRC 172

Claim of Right: Receipt

Income when held under claim of right

United States v. Lewis (S.

Ct. 1951)
1944: TP received bonus of $22,000.
Reported on return.

1946: Required to return $11,000 in 1946.

TP wants to amend 1944 return.
Government wants finality to 1944 return
and let TP have a deduction.
Is there a difference?
Yes, because deductions often limited.
(Remember gambling?).

Government wins

General Rule of Lewis

Past events can affect future tax returns.
E.g., adjustments to basis in 2014 affect
2015 gain if asset sold.

Future events cannot affect past tax

returns.
Determine 2014 taxes based on events up to
December 31, 2014, 11:59:59 pm.
Statutory exceptions (like section 172
carryback).

Claim of Right Summary

Receipt under claim of right is
income. NAOC.
Return of claim of right item is
potential deduction. Do not amend
old return. Lewis; see also Sanford &
Brooks.

IRC 1341
Problem is value of year 2 deduction
Many deductions are limited.
Tax rate may be lower in year 2.

Congress enacted section 1341 to

address problem.
Do not formally reopen year 1 return.
Year 2 return gives better of:
deduct or
credit for amount of year 1 overpayment.

Tax-Benefit Rule
Actual Recoveries
Suppose, in 2014, you prepay your 2015
rent on your business office. (Say,
$30,000.)
At the end of September 2015, you
leave and your landlord refunds you
$10,000.
You have $10,000 of 2015 income.

Section 111
Return to prior example. Suppose
that you deducted the 2014 rent
but you had no tax benefit from
the deduction. Perhaps your was
already negative.
Section 111 allows you to recover the
$10,000 of rent tax free.

Fundamentally Inconsistent
Events
Again, suppose you prepaid and
deducted your 2015 rent.
In 2014, however, you decide to
close your business. And, since you
paid for the 2015 rent already, you
move in to the office space and use it
as a personal residence until 2016.
Your personal use is fundamentally
inconsistent with the business
deduction.

Section 104(a)(2)
gross income does not include the
amount of any damages (other than
punitive damages) received (whether
by suit or agreement and whether as
lump sums or as periodic payments)
on account of personal physical
injuries or physical sickness

Rationale
Lenience for those suffering
misfortune. (Similarly, life insurance
proceeds are tax free.)
TP suffered a loss from the injury.
Recovery simply makes her whole.
As with Clark, though, TP who does not
recover does not get to deduct the
loss.

Scope
personal physical injuries
Not punitive damages
Not purely emotional distress

on account of
Emotional distress would be tax-free if
caused by PPI.
Same for lost wages

Periodic payments
In effect, tax-free interest.

Loan Proceeds
Not income.
No change in wealth.
Not held under claim of right.

Kirby Lumber (S. Ct. 1931)

Transaction
TP issues bonds and buys back a portion
of them.
Sold bonds for $1,000,000
Buys back for $862,000

Court holds there is $138,000 of

income.

CODI Theory
Freeing of assets
assets previously offset by the
obligation of bonds now extinct
Cf. also insolvent debtors (p. 149).

Consistency / Tax Benefit

Loans are tax-free.
Premise is repayment.

Zarin (3d Cir. 1990)

TP incurred gambling debts of $3.4
million.
Unable to pay, he settled for
$500,000.
IRS says difference of $2.9 million is
income to TP.
Held not taxable as debt was
disputed.

Haig-Simons
Keep it simple and assume that Zarin
borrowed $3 million and repaid
nothing.
Zarin had no change in wealth.
Did Zarin have $3 million in
consumption?
Seems implausible to say yes.
Note that we supplying a subjective
valuation. We might view a very wealthy
gambler differently.

Loss Deduction?
Suppose Aaron borrows $3.4 million
for a business. Business fails, and
Aaron repays creditor $500,000.
Aaron is easier than Zarin because
Aarons business failure probably
generates a deductible loss.
As for Zarin, see note 3, page 159

Enforceability?
Suppose Baron borrows $3 million
from an illegal lender in 2014. In
2015, court declares loan
unenforceable.
Does Baron have income? In what
year?