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Contributed by Roger Martin, 2L Student by night at Univ. of San Diego, Patent Agent by day at rmartin@qualcomm.com

** Old Colony Trust Company v. Commissioner, (1929)

2. Facts: Mr. Wood was president of a corporation. Old Colony is his executor. The corporation paid all income taxes on Mr. Wood's salary directly to the government so that his resulting salary would have no deductions for income taxes.

3. Procedural Posture: The Board of Tax Appeals found that the corporation's payment of the tax was income to Mr. Wood. The decision was granted review by the Supreme Court.

4. Issue: "Whether a taxpayer, having induced a third party to pay his income tax or having acquiesced in such payment as made in discharge of an obligation to him, may avoid the making of a return thereof and the corresponding tax."

5. Holding: No. The payment of income tax by an employer is a gain derived by the employee from his labor and is in consideration of the services rendered by the employee, and is therefore taxable against the employee as income.

6. Reasoning: The Supreme Court reasoned that the discharge by the company of the employee's obligation was a direct gain to the employee, regardless of the form of payment and the fact that it went directly to the government. Because the payment of his income taxes was in consideration for his continued employment, the payments constituted income to the employee. The Court rejected the argument that it was a tax on a tax as not being before them.

7. Notes: A. Third-party payments - Old Colony established the proposition that gross income includes economic benefit to a taxpayer resulting from the payment of an obligation to a third party. Any other approach would make it too simple to avoid taxation by restructuring cash payments to third parties. Also taxable as income are: payments of fines to government, etc.

B. Tax on a Tax - In Old Colony, the government only included in the gross income of the taxpayer the first layer or tax paid on behalf of the taxpayer. This only took into account the difference in tax owed based on the after tax compensation of the taxpayer and that actually paid by the company (the tax would have been more had the full salary been paid). However, a proper calculation would have included a "pyramiding" of the tax, and thus been assessed against the before-tax compensation. Ex: Taxes are $33,000 on an after-tax income of $100,000, but only $22,000 on a before-tax income of $100,000.

C. Other forms of benefit - In Armantrout v. Comm., disbursements from a school trust fund set up for the employee's kids were part of gross income to the employee. In U.S. v. Gotcher, the taxpayer went on a 12 day trip to Germany to visit the VW plant. VW paid 75% and Gotcher's employer, the other 25%. The court held that the trip expenses were not income because they were for the "primary purpose" of the "legitimate business purpose of the party paying the expenses." [This can be squared with Old Colony if one views the Old Colony payment as compensation to continue employment, and the VW payment as travel expenses of a potential business partner.] Similarly, the "convenience of the employer" test developed in Benaglia applies to expenses paid for by the employer but imposed on the employee (manager of a hotel got room and board tax free because the employer required him to be there). See also McDonnel v. Comm. (holding that taxpayer assigned to discuss business with customers on a vacation to Hawaii was not liable for tax on the value of the trip because it was primarily a working trip, not a vacation, even if they enjoyed it).

** Revenue Ruling 79-24 (Non-Cash Benefits), (1979)

2. Facts: Situation 1: In return for legal services, a painter paints the lawyer's house. Situation 2: An artist paid 6 months rent with a painting.

3. Statutes/Regulations: I.R.C. 61(a) and Regs. 1.61-2(d)

4. Issue: Are bartered services included in gross income?

5. Holding: Yes. If services are paid for other than in money, the fair market value of the property or services taken in payment must be included as income.

6. Notes: A. Other examples: Dean v. Comm., shareholder realized dividend income from rent-free use of house owned by corporation; Strong v. Comm., lessor of a cattle breeding herd realized rental income when calves born were added to the herd which remained in lessee's possession. B. Barter Exchange Clubs - even where the services are not contemporaneous, and instead "trade units" or credit is given (like money), the value received is still included in the year of receipt as income.

** Rooney v. Commissioner, (1987)

2. Facts: An accounting partnership regularly conducted business by receiving goods and services from their clients as payment for their services. This method was called "cross-accounting". Four of their clients became delinquent in their accounts, and so the accountants chose to patronize their businesses, receiving goods and services in lieu of cash as partial payment of the client's delinquent accounts. However, when reporting this income, the partnership "discounted" the value of the goods and services, claiming that although they were charged retail prices for the goods and services, the actual value to them was much less because they were "forced" to take payment in kind to avoid not being able to collect at all from the clients, who were on the brink of going out of business. The partners never told the clients that they were discounting.

3. Statutes/Regulations: IRC 61(a) and Regs 1.61-2(d).

4. Issue: May an accounting partnership discount the value of goods or services received according to the partner's subjective valuation of the goods or services when computing income?

5. Holding: No. The proper measure for the value of compensation made in other than cash terms is the objectively determined fair market value of those goods or services.

6. Reasoning: The court reasoned that if any subjective valuation was used, then the tax system would be unworkable because the IRS can not be concerned with the subjective state of mind of the taxpayer. Furthermore, they rejected the argument that the partners were under economic duress because, although the partners claim they would not have paid as much for the services, other customers regularly paid that much.

7. Notes: A. Fair Market Value is defined in the Estate Tax Regs as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts." Regs. 20.2031-1(b). However, in Turner v. Comm., the tax court held the value of non-transferable steamship tickets won by the taxpayer at 2/3 their value because they would not have purchased them for themselves. B. Bargains - a taxpayer is required to pay tax only on the actual "price" value of the services he obtains, even if they are less than the market value. For example, in Pellar v. Comm., a taxpayer who received intentionally discounted services from a contractor because of a preferential business relationship did not recognize gross income on the difference between the discount price and the regular price the contractor charged. [Pellar can be reconciled with Rooney only if the test is whether the service provider charged less for his services, or the taxpayer discounted the value of the services independently. In the former, the market differential is not includable as income, while the latter is.] However, when the service provider intends the discount to be compensation to the taxpayer in return for the taxpayer's goods or services, then the market differential value is includable as income to the taxpayer.

** U.S. v. Drescher, (1950)

2. Facts: Drescher was an employee of Bausch and Lomb who was given voluntary retirement before he reached 65. He was given, in "recognition of prior services rendered" a non-transferable annuity that would begin to pay when he reached 65 in 1958 (or to his designated beneficiary if he died), for which the company paid a premium of $5,000, and deducted as compensation to Drescher. The policy had no cash surrender value. It was only a guaranteed future income stream for himself or his beneficiary.

3. Statutes/Regulations: I.R.C. 61(a) includes "compensation for personal service, of whatever kind and in whatever form paid."

4. Issue: What is the includable income value of the annuity in the present tax year? Is it the price of the premium paid by the company ($5,000), or is it zero because the annuity gives the taxpayer no present income?

5. Holding: The present value of an annuity which is non-transferable is equal to the cost to the taxpayer of acquiring identical rights.

6. Reasoning: The court reasoned that the value lie somewhere between the premium price paid and zero. Even though the taxpayer might die before the annuity started paying, he had some present rights to a future income stream which he could designate to a beneficiary. Furthermore, the taxpayer could realize present cash payment from a third party who he could designate as a trustee to hold the future payments in trust for him. However, this would probably be worth less than the premium paid by the company based on the risk of the taxpayer dying before the annuity began paying, and thus the payments going to the beneficiary. However, the burden of proof was on Drescher to show that the present value was less than $5,000.

7. Dissent: The dissent reasoned that the value was the amount paid by the company because it represented the present value of the future payments, and was consideration for the contract between the taxpayer and the company. The dollar amount of the policy premium represented what the market expected the present value of the aggregate payments over Drescher's life to be, which was greater than $5,000.

8. Notes: A. As a result of the Gov't victory in Drescher, he would be required to pay taxes currently on the present value of the policy ($5,000), plus future taxes on any payments greater than $5,000 if he lived long enough. Drescher would have gotten the same value in present terms if the company had given him a cash bonus large enough so that after taxes he would be left with $5,000. An annuity is deferred compensation.

I. Imputed Income (Excerpt from Marsh, The Taxation of Imputed Income)

A. Definition - "a flow of satisfaction from durable goods owned and used by the taxpayer, or from goods and services arising out of the personal exertions of the taxpayer on his own behalf."
1. By definition, it is a species of non-cash or income in kind which arises outside of the normal market.
2. Examples:
a. Imputed rent - net value of the services rendered by a house to its owner which he otherwise would have had to pay a landlord.
b. Imputed interest - use of durable goods
c. Imputed wages - value of services rendered for oneself, such as mowing the lawn, housework, subsistence farming.

B. Imputed income, like all income, increases a taxpayer's buying power. Thus, this drives decisions to do work yourself and avoid the tax on the extra money you would have had to make to hire out the same work.
1. Taxing imputed income would broaden the tax base, but might not be able to be assessed properly.
2. Also, high administrative costs would probably outweigh the value of the tax collected because people don't normally do a wide variety of highly valuable things for themselves.
3. However, imputed income from residential rent, or cars, etc., might be more easily measurable.

C. Notes:
1. Rental Value: In some European countries imputed rent is taxable as income. In the U.S. it is generally believed that imputed rent is not unconstitutional.
2. Farm products consumed by Farmer: Reg. 1.61-4(a) states that "crop shares" which are the landowner's cut of crops grown by a third party on his land are taxable income. However, homegrown food for one's own use is not under Morris v. Comm..
3. Payments to Oneself: commissions paid by a partner in a firm to the firm itself, of which he shared in the profits, were held to be non- taxable to the extent they could be traced to him directly.

I. Employee Benefits as Income

A. Many fringe benefits are valuable to the employee, and have been traditionally non-taxable.
1. Discounts on company goods and services leads to potential discrimination in benefits among employers because some employers have more desirable goods than others.
2. Also, benefits to higher-paid employees are normally given as a way to avoid income tax liability.

B. The Deficit Reduction Act of 1984 sought to exclude only certain benefits to widen the tax base in a fair manner.
1. No-additional-cost services - Sec.132(b) where the employer provides a service to the employee for a discount, it is excludable if the employer incurs no additional cost by providing it, including foregone revenue.
a. Example: employee can use excess capacity of employer while not being used by customers (airline stewardess flying free to any destination with extra seats).
b. Must be the same type of service sold to the public in the ordinary course of business in which that employee works. (Thus, an employee of a conglomerate can not use company owned hotel rooms if she is only a airline stewardess).
c. Must be something that the employee would not have purchased for himself at market price (otherwise it is lost revenue).
d. Can be provided by a third party employer as long as there are reciprocal benefits to that company's employees. Sec.132(i).
2. Qualified Employee Discount - Sec.132(c) the amount of the exclusion is subject to a limitation based on the employer's gross profit percentage, normally a max. of 20% (otherwise the employer would be losing money).
3. Working Condition Fringe - Sec.132(d) excludable if the property or services would have been deductible by the employee individually as an ordinary and necessary business expense, but instead was provided by the company.
a. Ex: company car used for business purposes (not personal use).
b. Ex: employer pays for subscription to magazines, or professional membership dues.
4. De Minimis Fringes - Sec.132(e) otherwise includable income that is so small that the cost of accounting for it would be impractical.
a. Ex: occasional personal use of company resources (copier, car, meals, etc.)
5. Qualified Transportation Fringe- Sec.132(f) employer provided parking, transit passes, etc. are excluded to a maximum limitation.
6. Qualified Moving Expense Reimbursement Sec.132(f) only reasonable costs and expenses of the actual move are excluded, not house-hunting money.
7. Non-discrimination - Sec.132(i) Each of these exclusions is available to highly compensated groups (officers) only to the extent substantially the same benefits are offered to others.
a. Nondiscrimination is only applicable to no-additional-cost and employee discount fringes, not working condition or de minimis fringes.

C. Sec.119 Meals or lodging furnished by the employer
1. Cost of meals and lodging is excludable if it is "for the convenience of the employer," even if the employee is thereby convenienced, and it is provided for a "substantial non-compensatory reason".
2. Sec.119 only covers meals or groceries furnished in kind, not cash provided as a meal allowance.
3. Sec.119 also covers meals furnished to the employee's dependents because of difficulties in separating the value of those services from the value to the employee.
4. Sec.119 the meals and lodging must be provided on the employer's "business premises" - but simply being close and "on call" is insufficient.

D. Other Fringe Benefits
1. Life Insurance - Sec.79 excludable up to $50,000 group-term life, and subject to the non-discrimination rule for key employees.
2. Health Benefits - Sec.105 and Sec.106 "Sick pay" is not excludable, however:
a. Medical payments tied to the type of injury suffered, not relating to the period the employee is absent from work are excludable.
b. Still subject to non-discrimination.
3. Qualified Educational Benefits Sec.127 - excludes up to $5,250/yr. paid by employer or discounts to university employees.
4. Dependent Care Sec.129 excludable for children under 13 as long as there is a non-discriminatory written plan.
5. Group legal services Sec.120 qualified exclusion up to $70 in legal insurance.
6. Cafeteria plans - Sec.125 the choice between taxable and non-taxable benefits will make an otherwise excludable benefit includable.

E. TAXABLE Benefits - anything not specifically excluded under statute becomes includable under Sec.61(a).
1. Most exclusions are not based on sound tax policy reasons, but rather other policy objectives, and therefore distort consumer choices. a. Why should a person who is lucky enough to enjoy a tax-free benefit pay no tax when another consumer is forced to pay for the same service with after-tax dollars?

** Commissioner v. Duberstein, (1960)

2. Facts: Situation 1: Duberstein was the president of a metal company. He frequently conducted business with, and gave business leads to, a Mr. Berman, who was the president of another metal company. Duberstein knew Berman "personally". Because of the helpful business leads that Duberstein provided, Berman gave Duberstein a Cadillac. Berman claimed a business deduction for the Cadillac, but Duberstein did not include it as income.
Situation 2: Stanton was the comptroller of a church corporation. After tendering his resignation amidst some ill-feeling, the church corporation resolved to give him a "gratuity" of $20,000 "in appreciation of services rendered...provided that the [church corporation] be released from all rights and claims to pension and retirement benefits."

3. Statute/Regulations: Sec.102 on gifts (actually, its predecessor).

4. Issue: May a transaction between persons who are involved in a business relationship be categorized as a gift?

5. Holding: Yes. Whether a transaction between persons who are involved in a business relationship may be categorized as a gift, and thus excludable as income, is a question of fact to be determined on a case- by-case basis, and not a matter of law.

6. Reasoning: The majority followed the dissenting opinion in Bogardus v. Commissioner, that the "intention" of the transferor (objectively determined) is what is controlling as to whether a transfer is a gift. They rejected the Government's proposed test that if business were involved then it could not be a gift as a matter of law. Since intention is a question of fact, the Court stated that a workable test of law could not be fashioned, but that consideration of all the circumstances must be taken into account. Thus, whether a business "gift" is taxable should be left to the trier of fact's experience. The gift should be made with "detached or disinterested generosity".

7. Notes: A. The Gift Tax statute definition of a gift is not the same as the income tax definition.

B. Generally, employer payments to employees "in appreciation" after they have left are taxable as income, and are not considered gifts. Section 102(c) requires all transfers to employees fro employers to be included as income. However, it seems to only apply to a current employer/employee relationship, and not "in appreciation" gifts like that in Duberstein. Likewise, it does not seem to apply to independent contractors.

C. Death Benefits - although they have had a history of inconsistency between the District Courts and the Tax Court, Sec.101(b) now excludes from gross income amounts up to $5,000 paid by an employer to the beneficiaries of a deceased employee, but only if the employee's right to receive the amounts was forfeitable while he was alive. This exclusion applies regardless of whether it can be considered a gift. D. A business "gift", if deductible by the donor, would be excluded entirely from the tax base if it were excludable by the donee. Thus, Section 274(b)(1) denies business deductions in excess of $25 per person per year. Theoretically, this taxes the wrong person, but keeps the gift in the tax base. Combined with death benefits, a company can give $5,025 to a surviving spouse under Sec.Sec.102 and 101.

E. Tips are included in gross income under Regs 1.61-2. This includes chips given to craps dealers. The IRS, in Sec.6053, has taken the general rule that 8% of gross receipts are includable in income as tips, based on random surveys of tipping behavior among patrons. Strike benefits are normally taxable unless clearly based only on need and not tied to picketing requirements. Public appeals for money can be taxable even if there is no legal obligation to pay because it is assumed that the paying party is not simply giving out of "disinterested generosity." A person is entitled to treat transfers from a lover as gifts unless they are specific payments for specific sex acts. Generally, bequests are excludable under Sec.102, however, if they are used for compensation to a taxpayer who has provided a service to the deceased, they are includable.

** Irwin v. Gavit, (1925)

2. Facts: Testator left the residue of his estate in trust to be divided into parts. Some income from the estate was to be paid to the testator's son in law, in equal quarterly payments, for his life, or until testator's granddaughter reached 21, whichever was sooner.

3. Statutes/Regulations: The lower court found that the payments received from the estate were acquired by bequest and thus were not taxable under statute. The modern statute is Sec.102.

4. Issue: Is the income from an estate includable as income even though the bequest is made of the income of the estate and not the estate itself?

5. Holding: Yes.

6. Reasoning: The court reasoned that the broad language in the statute that stated that income from whatever source derived included income from an estate, because it was not specifically excluded by statute. The court stated that it was artificial to hold that the income from the estate was a gift separate from an interest in the estate itself. It was already settled that the estate was excludable, but the income from the estate was not excludable. Thus, since the income of the estate could not be separated from the estate, it could not be classified as a gift on its own to get around the provisions for inclusion of income on a gift.

7. Notes: Under Irwin and Sec.102(b), if a $100,000 gift is made in trust to A to live off the income for life, and then the whole amount over to B, then B excludes the entire $100,000 from income, but A includes the income on the trust during his life.

I. Life Insurance Death Benefits (Sec.101).

A. Life insurance is defined by Section 7702. It must have the element of insurance risk.
1. Ex: If a life insurance policy is granted only if the person buys an annuity whose premium is equal to the face value of the life insurance policy, then there is no insurance risk, and the proceeds are taxable against the beneficiary.
2. Sec.7702 covers the situation where there is a current cash surrender value and interest being made on the policy. The interest earned on the savings portion of the policy is taxable.

B. Installment Payments
1. If the only amount that the beneficiary can receive is the face amount of the policy, then the full amount of the proceeds is excludable under Sec.101(a) regardless of the method of payment of the proceeds.
2. However, if the beneficiary leaves the proceeds with the insurance company under an option to pay the face amount in installments, the insurer will pay interest which is includable as income to the beneficiary.
3. Generally the present value of the policy at the death of the testator is excludable.

C. Commercial Transactions
1. If a creditor insures the life of a debtor to secure repayment of the a loan, the creditor only receives the amount of the debt. Thus, the amount received is not "by reason of the death of the insured" and so Sec.101(a) does not exclude the receipt.
2. If the taxpayer receiving the proceeds had bought the policy from another, then any gain resulting (excess of proceeds over purchase price plus later paid premiums) is includable under 102(a)(2) even though the entire proceeds would have been fully exempt if the policy had been taken out by the taxpayer himself.

D. Employee Death Benefits
1. 101(b) excludes $5,000 of post-death payment to the surviving spouse by an employer, even though such payments are usually deferred compensation.
2. 101(b) does not apply to amounts which the employee had a non- forfeitable right prior to death, such as accrued vacation pay, or any guaranteed deferred compensation.
3. 101(b) does apply to payments pursuant to a contract expressly providing for the payment of a benefit if the employee dies during the period of employment.

I. Prizes (Section 74)

A. Prizes are generally includable as income to the payee.
1. Prizes are excludable only if:
a. the recipient was selected without any action on his part to "enter" the contest (such as Nobel Prize);
b. the recipient is not required to render substantial future services as a condition of the prize; and
c. the prize is transferred directly to the government or a non-profit organization designated by the recipient. (direct donation).
2. Scholarships are not governed by Sec.74, but rather Sec.117.

B. Valuation of Taxable Prizes
1. Reg. 1.74-1(a)(2) requires that non-cash prizes be included as income at their fair market value.
2. However, the courts might take into account the subjective value to the individual recipient based on the probability that the recipient would have made an expenditure to buy the prize for themselves.

C. Employee Achievement Awards
1. Sec.74(c) excludes employee achievement awards to the extent that the award does not exceed the amount allowable as a business deduction to the employer.
2. Sec.274(j) requires that the award be personal property, awarded for length of service or safety, be part of a "presentation", and not look like disguised compensation, probably $400 or less.

I. Scholarships (Section 117).

A. In general, scholarships and tuition reduction for degree candidates are excluded from gross income to the extent that they do not represent any form of compensation, but are "disinterested" scholarships with no strings attached.
1. The scholarship can only be used for tuition, fees, books and "course related expenses", not room and board. The amount of the scholarship is excludable only to the extent that the student has incurred these costs.
2. This applies to all levels of education from primary through graduate, including accredited trade schools, but not correspondence schools or on the job training or the like.
3. Amounts received for teaching, research or other services are includable as income to the extent they represent compensation, if they are a condition of the scholarship or tuition reduction.
4. Educational loan forgiveness is includable if it requires the recipient to restrict his services (stay with a company, practice in only rural areas, etc.)

B. Employer Provided Education Benefits - Where an employer pays, directly or indirectly, education costs of its employees, Sec.117(a) is not applicable, and thus the income is includable if not qualifying as a tax-free fringe benefit under Sec.132.

C. If someone other than the student wins a scholarship intended to be for the benefit of the student, it becomes taxable as a prize under Sec.74.

D. Policy Issues - the exemption of scholarships probably should be analogous to the gift to a student from the family to pay for education. Intra-family gifts are non-taxable to the student, so should scholarships be non-taxable.

** Commissioner v. Glenshaw Glass, (1955)

2. Facts: Situation 1: Glenshaw Glass was involved in a long and protracted anti-trust suit against a machinery manufacturer. It was eventually settled for $800,000, of which, $324,000 was allocated as payment of punitive damages. Glenshaw did not report this amount as income, and the Commissioner claimed it was a deficiency. Situation 2: William Goldman Theaters sued Loew's for antitrust violations. Their actual damages were $125,000, which they reported as income, but they did not report the other 2/3 of the treble damages awarded.

3. Statute/Regulation: Sec.61(a)'s predecessor: income derived from any source whatever. Both the Tax Court and the Court of Appeal held in favor of the taxpayer.

4. Issue: Are punitive damages awarded by a court, or settlements in excess of actual damages includable as income?

5. Holding: Yes.

6. Reasoning: The court reasoned that there were no constitutional barriers to the imposition of a tax on punitive damages. Furthermore, the broad language of the statute defining gross income evidenced Congress' desire to exercise their taxing power fully. Punitive damages represent "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." For the same reason that the actual damage recoveries are taxable, the extra amount extracted for punishment is also taxable.

7. Notes: A. In General American Investors Co., Inc. v. U.S., the company recovered moneys from a director employee who had been guilty of insider trading. The Supreme Court held that this was includable as taxable income. B. In Haverly v. U.S., an elementary school principle received unsolicited copies of books from various publishers. The principle gave the books to a local library, and then claimed a charitable deduction on them. The court held that the value of the books constituted income, although they seemed to indicate that if he had not taken a deduction for them, then it would have been a more difficult case. C. The finder of a treasure trove of lost money is taxable to the extent of its value in U.S. currency in the present tax year.

** North Am. Oil Cons. v. Burnet, (1932)

2. Facts: The Government owned the property that the company possessed. The Gov't sought to oust the company from possession, and so set up a receivership to take the company's profits for 1916. The company paid the receivership the profits, and a suit proceeded for possession. In 1917, the District Court entered a decree for the company, awarding them the profits previously paid to the receivership. The Gov't took an appeal, which was ultimately affirmed in 1922.

3. Statutes/Regulations: Sec. 13(c) of the Revenue Act of 1916.

4. Issue: At what time do profits which are subject to litigation become includable as income to the taxpayer?

5. Holding: Litigated profits become income of the taxpayer when they first become entitled to them under a claim of right (a judgment), regardless of whether the case is subsequently appealed.

6. Reasoning: The court reasoned that the company did not have constructive receipt of the profits in 1916 when it paid them over to the receivership because they had no claim of right to them. The outcome of the pending case was uncertain. However, upon the first judgment in their favor, they had constructive and actual receipt of the money, regardless of any pending appeal. Even though the outcome of the appeal was uncertain, in 1917 they were given a judgment for the money and so had to make a return for it. Had the appeal gone the other way, they would then have been able to claim a deduction against their 1922 profit.

7. Notes: A. Amounts received under a claim of right and without restriction as to their disposition constitute income in the year of receipt, even though the taxpayer may ultimately be required to restore an equivalent amount in a subsequent judgment. [This differs from loans which are not taxable because it does not involve "true" debt where the receiver is under an unconditional obligation to make repayment.]

B. The receipt is includable as income even if "set aside" in a special account with the intention of not using it until final judgment (Comm. v. Alamitos Land Co.), or even if a bond is filed as security for repayment in a final judgment (Comm. v. Brooklyn Union Gas Co.), but not if the receipt is deposited under conditions preventing it from being under the dominion of the taxpayer, such as a payment into the court clerk pending final judgment (Rev. Rul. 69-642).

** James v. United States, (1961)

2. Facts: James admitted to embezzling funds from his employer. He did not include the embezzled funds on his tax return.

3. Statute/Regulation: Section 61(a).

4. Issue: Are embezzled funds includable as income to the embezzler in the tax year embezzled?

5. Holding: Yes.

6. Reasoning: The majority, overturning a previous ruling concerning taxation of embezzled funds (Wilcox), reasoned that section 61(a) language which included all income from whatever source derived, included embezzled funds in the same way that it included all other illegal income such as extortion (Rutkin). The embezzler, they reasoned, had received income which he could exercise dominion over and realize present economic benefit from, even though he may be required to repay it at a later date. The embezzler should not be able to avoid taxes when the honest man has to pay. If the embezzler were required to pay back the debt, then he could claim a deduction. The embezzled funds could not be termed a "loan" because they did not arise out of a "consensual recognition" between he two parties to repay the debt. However, the court reversed this particular defendant's conviction because he could have not acted willfully if he had been relying on Wilcox to relieve him from obligation to pay taxes on the embezzlement.

7. Dissent: The dissent reasoned that an embezzler does not gain any claim of right to the money he embezzles until the statute of limitations runs. The embezzler has effectively "borrowed" the money without the consent of the owner, and so he should be treated like a borrower of legal debt.

8. Notes: B. Under RICO, a racketeer or drug dealer forfeits the title to any property he gains to the government as of the day he gains it. Thus, technically he never had a claim of right. However, he is still required to pay income tax on the gains, even though he can not claim a deduction for the forfeiture. C. Even if an embezzler subsequently turns himself in and negotiates repayment to the victim, his illegal income is still taxable under the rule in James because it was not consensual at the time of creation. [There was a finite time where the embezzler had dominion over the money with the opportunity to use it.] However, a taxpayer who fully intends to repay a debt, who reasonably expects to be able repay the debt, and who has reasonably expected the lender to consent to the debt is not required to include the amount of the debt as income even if the lender then refuses to consent. Gilbert v. Comm.. D. The Government's claim to taxes on illegal income often conflicts with the rightful owner's interest in recovering the full amount of embezzled, especially where the embezzler's assets are few. However, the rightful owner may be able to recover the full amount ahead of the Gov't tax lien, or even recover the taxes directly from the Gov't after the embezzler has paid. This conflict is worst when the embezzler is declared bankrupt because Congress has given tax liens have a high priority under the Bankruptcy Act.

** Comm. v. Indianapolis Power & Light Co., (1990)

2. Facts: IPL is the power company. They require certain customers to provide a security deposit approximately equal to twice their estimated monthly bill. These funds can be refunded to the customer with interest upon the showing of satisfactory credit, or they can be applied to the customer's bill at the option of the customer. IPL did not claim these deposits as gross income, even though they commingled the deposits with their general funds. However, they counted them as liabilities in their books.

3. Statute/Regulation: 61(a).

4. Issue: Are security deposits made to a utility company considered gross income?

5. Holding: No.

6. Reasoning: The court reasoned that the security deposits did not represent advanced payments. They rejected the Government's argument that since the IPL gained economic benefit from the deposits that they were income. They reasoned that since the disposition of the funds lay with the customer, and not IPL, then IPL did not exercise the requisite amount of control over them to be income. The fact that IPL gained an economic benefit, meaning the chance to earn more money on the deposits, was not determinative, because it is assumed that in the case of a loan that the borrower gains some economic benefit greater than the interest he pays. The distinguishing factor that made these deposits like loans was that IPL could not, at its own choice, apply the money to the payment of electricity. Thus, these were not advanced payments. Like a loan, the customer (lender) retained control over the manner in which they could be applied or refunded. Thus, it was never certain that IPL would keep any part of the deposit. However, the court realized that this could pose problems for private transactions where the company was not closely regulated.

7. Notes: A. The tax courts have expanded the scope of IPL to apply to the cases where the deposit was non-interest-bearing (Oak Ind., Inc. v. Comm.), and even where it was only applicable as a rebate against future charges (Kansas City Southern Ind., Inc. v. Comm.).

1. Eisner v. Macomber, (1920)

2. Facts: The taxpayer owned 2,200 shares of stock in a company. The company declared a 50% stock dividend in 1916, so the taxpayer received an additional 1,100 shares of which 198.77 shares represented the surplus of the company earned between 1913 and 1916. The shares that represented the surplus had a par value of $19,877 and the Commissioner treated the par value of these shares as income to the taxpayer. The taxpayer asserted that the stock dividend was not income under the 16th amendment. The District court found for the taxpayer.

3. Statutes/Regulations: The sixteenth amendment, and articles of the Constitution. Definition of income under the Revenue Act of 1916.

4. Issue: Is the payment of a stock dividend, as opposed to a cash or in kind dividend, to a stockholder of a company includable as income to the stockholder?

5. Holding: No.

6. Reasoning: The Court understood a stock dividend to be a method of recapitalizing surplus, and spreading that capital among the stockholders in proportion to the shares that they held. Thus, the shareholder's capital investment had grown and was worth more if it were to be sold, but he still owned the same proportion of the company as he did previously. A stock dividend takes nothing from the property of the company and adds nothing to that of the shareholder. The sixteenth amendment gave Congress the power to tax "income", and in the common meaning of the word, "income" did not include unrealized gains that were still the property of the company. Using Towne v. Esiner's definition of income being a "gain derived from capital" under the Revenue act of 1913, the Court analogized "capital" as being separate from "income" in the way that a tree is separate from its fruit. The Government argued that it was nevertheless a "gain" to the stockholder because it could be sold for more. However, the Court stated that the taxpayer had not sold yet, and that his investment was still exposed to the business risks that could wipe it out. The taxpayer does not realize increased worth in property unless he receives "something of exchangeable value proceeding from the property." A stock dividend is different from a cash dividend which is subsequently reinvested because cash dividends actually transfer the company's property to the stockholder. A stock dividend does not.

7. Dissent: Holmes argued that the meaning of the 16th amendment was to put to rest any questions as to what might be direct taxes. Thus, "income" should be interpreted in that light. Brandeis argued that a corporation should not be differentiated from a partnership. A partnerships' profits are taxable to the partners even if they have not yet been distributed.

** Cottage Savings & Loan v. Comm., (1991).

2. Facts: Cottage is an S&L who owned several long-term, low-interest mortgages which depreciated in value in the 1970's when interest rates surged. To avoid possible closure by the Federal Home Loan Bank Board if they had sold their devalued mortgages outright and taken a loss on their books, they instead exchanged 90% interests in 252 of their mortgages for 90% interests in 305 of other S&L's mortgages with an equivalent fair market value at the time of exchange. However, the face value of the mortgage interests that Cottage exchanged was approximately two million dollars higher than the face value of the mortgage interests they received. Thus, Cottage took a business deduction on the loss, while still retaining mortgage interests.

3. Statutes/Regulations: Section 1001(a) and Regs 1.1001 on the definition of "realization" of gain from the disposition of property.

4. Issue: Is there a realization of a gain or loss from the exchange of interests in mortgages where the mortgages are made to different obligors and secured by different homes?

5. Holding: Yes. An exchange of property gives rise to a realization event so long as the exchanged properties are "materially different" - that is, so long as the embody legally distinct entitlements.

6. Reasoning: The Court recognized that taxes were only assessed against realized gains as an administrative convenience. Otherwise, it would be difficult to value any increase or decrease in the yearly value of property. However, when property is sold or otherwise disposed of, it is straightforward to determine the valuation. The Court deferred to the Commissioner in requiring a "material difference" of the property exchanged in order to constitute "disposition" under the Regs 1.1001. However, the Court defined "material difference" as being legally distinct entitlements. The Court rejected the Gov't argument that there the test for "material difference" should depend on the market and the relevant regulatory agency's subjective consideration of the materiality of the difference. The Court stated that the valuation problem required no more than determining the difference in legal entitlements between the two properties.

7. Dissent: The dissent, although agreeing that realization required a "material difference" in the properties, concluded that under these facts, there was not a difference in substance, but only in form. Superficially they were different, but the lack of attention that the parties paid to the differences was evidence that they considered the properties to be materially the same.

8. Notes: A. The impact of the Eisner v. Macomber realization requirement is that tax on capital investment is deferred until the profit can be separated from the capital. This creates a tax advantage for long-term investments that do not pay yearly dividends over those that do. On a $100 investment at 8%, the difference is almost 10% after tax profit if the interest is recapitalized in the investment rather than paid to the taxpayer yearly and then reinvested. B. Eisner may have been too broad in declaring the Revenue Act of 1916 as unconstitutional to the extent that it taxes stock dividends. Subsequent Supreme Court cases have limited its holding to only provide for a realization requirement. In recent years however, Congress has enacted some provisions that tax some gains on an accrual rather than a realization basis. C. Regs 1.1001 applies to both gains and losses. Thus, if the Commissioner would have won, it is likely that there would have been lost revenue from taxpayers who had gained by exchanges of similar properties. Some sections provide for the moving of capital between different real estate properties without recognizing gain. Similarly, an exchange of the stock of a corporation for another in a reorganization or acquisition may be tax-deferred. D. In the case of stock dividends that increase the stockholder's proportional interest in the company, such as when stockholders are given a choice between cash or stock dividends (and some choose cash, thus decreasing their proportional share with respect to those who chose stock), the increase in proportional interest is taxable. E. Section 109 excludes income derived by a lessor of real property on termination of a lease attributable to buildings or other improvements constructed by the lessee. However, Section 1017 provides that the lessor's basis for the property shall not be increased or decreased by the lessee's improvements. Thus, if the lessor sells the property, his gains or losses will be realized on the low basis, or if he re-leases the property for a higher value because of the improvements, his low basis provides reduced depreciation reductions. F. Section 475 requires securities dealers to "mark-to- market" their securities and report accrued gains or losses as taxable, even though no realization has occurred from sale.

I. Gifts and Basis

A. General
1. Section 1015 provides that if the fair market value of the gift is greater than the donor's basis at the time of the gift, then the donor's basis becomes the donee's basis, and the accrual is not taxed at the time of the gift.
2. However, if the fair market value is less than the donor's basis at the time of the gift, then the donee's basis for determining losses becomes the fair market value at the time of the gift, rather than the donee's basis. This prevents a donor from shifting an unrealized loss to the donee.

B. Gift Tax
1. Generally, any gift taxes paid on the appreciation in the property at the time of the gift become add to the basis of the donor. Section 1015(d)(6).
2. The result is that the overall tax consequence is the same whether the donor sells the property and gives the proceeds, or the donee sells the property and pays tax on the gain.

C. Special Rules for some gifts.
1. Section 84 provides that the donor is taxed on the appreciation of property made as gifts to a political organization.
2. The political organization's basis then becomes the fair market value at the time of the gift.

D. Part Gift and Part Sale
1. If a gift is made where the donee pays the donor more than his basis for the property, but less than the fair market value, then the donor's is taxed on the gain he makes, and the donee's basis becomes his cost under Regs 1.1001-1(e) and 1.1015-4.
a. Ex: in Diedrich v. Comm., the taxpayer gave stock to his children, but they had to pay the gift tax. Thus, the taxpayer was taxed on the difference between his basis and the amount of gift tax relief he obtained.
2. If the gift is made to a charity, however, the basis of the two parties is adjusted according to the proportion of the amount of the sale and contribution.

II. Transfers at Death
A. Generally, if the decedent's assets have appreciated, at his death, the inheritor's basis is "stepped up" to equal the fair market value at the time of death. Section 1014.
1. Any appreciation in the decedent's property will never be taxed.
2. Any depreciation in the decedent's property will never be deductible.
3. Thus, a taxpayer should sell all depreciated property before death, while holding any appreciated property.

** Clark v. Commissioner, (1939)

2. Facts: Clark was paid $19,941 by his tax counsel in 1934 to compensate him for his tax loss based on bad advice. The amount represents the difference between the taxes he would have paid if he and his wife had filed separately, and the amount he did pay based on his tax counsel's advise to file jointly.

3. Statutes/Regulations: The predecessor of 61(a).

4. Issue: Is compensation for losses of capital includable as income?

5. Holding: No.

6. Reasoning: The court reasoned that the compensation for loss was not includable because it was not "derived from capital, from labor or from both combined." They rejected the gov't argument that the amount constituted taxes paid by a third party on the taxpayer's behalf. Clark paid his own taxes, and the compensation represented a return of capital to him. It was not income to him as long as he did not take a deduction for the loss previously.

7. Notes: A. Damages for libel and slander and personal injury are analogized to Clark as a return of "human capital." B. Whether punitive damages for personal injury are excludable under 104(a)(2) is not clear. C. Even if the compensatory damages are non-taxable, any interest received with respect to the compensatory damages is taxable.

** Raytheon Production Corp. v. Commissioner, (1944)

2. Facts: Raytheon developed and patented a rectifier tube and licensed several radio manufacturers, building a large business of good will. RCA developed a competing tube and licensed it to many of the same manufacturers, including Raytheon, with a clause 9 that stated that the licensee would only buy from RCA. Over the next few years, Raytheon's market share declined significantly due to RCA's licensees being contractually bound to buy only from RCA. By the end of 1927, RCA's conspiracy and monopolistic practices had completely destroyed Raytheon's business and its good will at a time when it had a present value in excess of $3,000,000. Raytheon sued RCA for anti-trust violations. RCA countersued for non-payment of licensing fees. RCA got a judgment against Raytheon for $410,000 for non-payment of fees, and then Raytheon and RCA settled the anti-trust suit for the same amount, $410,000, including rights to some 20 patents. RCA refused to make an allocation of how much of the settlement was for the patent rights and how much was for damage to Raytheon's good will. Raytheon estimated the value of the patents at $60,000, and so made a return claiming only the $60,000 as income and excluding the remaining $350,000.

3. Statutes/Regulations: Predecessor to 61(a)

4. Issue: Whether an amount received by a taxpayer in a settlement of a suit for damages under the Federal Anti-Trust Laws is a non-taxable return of capital.

5. Holding: A settlement of a suit to recover damages for the destruction of business and good will is a return of capital to the extent that it does not exceed the taxpayer's basis in that business.

6. Reasoning: The court reasoned that the general rule was that recoveries that represent reimbursement for lost profits are income. They developed a test for taxability of the recovery based on "[i]n lieu of what were the damages awarded?" However, they reasoned that the evidence of profitability here was introduced only to show the value of the business and good will. But because they were being compensated for loss of capital, the capital could have appreciated since Raytheon had made the investment. Any compensation in excess of Raytheon's cost would be income. In this case, since the business and good will had been entirely destroyed, the amount in excess of Raytheon's cost was readily determinable.

7. Notes: A. Determining whether a payment is for lost profits or for damage to property may be difficult where a suit seeks damages on account of both, or where it is settled without an accounting as to the amount attributable to each. In Sager Glove Corp. v. Commissioner, payments in settlement of an antitrust action were taxable as ordinary income, not excludable as a return of capital, because the amount of the settlement was nearly the same as what the taxpayer had claimed in the suit to be lost profits. Liquidated damages provided for non-performance of a contract are treated as ordinary income, not a recovery of capital. B. When the property has not been totally destroyed, and the taxpayer receives a judgment, Inaja Land Co. v. Commissioner indicates that at least where the damaged portion of the property is not divisible from the undamaged portion, the recovery is entirely a return of capital up to the amount of the basis. Thus, the first "x" number of dollars goes to the basis (return of capital), and only the excess is taxable.

** Threlkeld v. Commissioner, (1986)

2. Facts: Threlkeld was paid $21,500 in damages in 1980 as part of a settlement agreement for a malicious prosecution suit. Because of the malicious prosecution, Threlkeld's professional reputation was damaged and he lost income.

3. Statutes/Regulations: 104(a)(2) providing that damages for "personal injuries or sickness" are excludable and 1.104-1(c) defining "damages received" as being based on tort or tort-type rights.

4. Issue: Whether damages received as part of a settlement for a malicious prosecution suit which represented damages to a natural person taxpayer's professional reputation are excludable under section 104.

5. Holding: "Exclusion under section 104 will be appropriate if compensatory damages are received on account of any invasion of the rights that an individual is granted by virtue of being a [natural] person in the sight of the law."

6. Reasoning: The court considered its previously overruled decision in Roemer v. Commissioner, where the Tax Court of Appeal ruled that there is no proper distinction between the damages to a person's personal reputation and the person's business or professional reputation when excluding damage awards under section 104. That court stated "The nonpersonal consequences of a personal injury, such as a loss of future income, are often the most persuasive means of proving the extent of the injury that was suffered." However, "[t]he personal nature of an injury should not be defined by its effect." In the case of a professional person, the amount of income lost is an accurate measure of the personal injury. The court then used common law tort principles to determine that malicious prosecution was a "personal injury" of a tort or tort-type nature under the Regs.

7. Dissent: The dissent reasoned that allowing damages which were measured by the loss of professional income to be excluded as a personal injury under section 104 would be to stretch it too far.

** United States v. Burke, (1992)

2. Facts: Burke was awarded damages from a settlement of a Title VII action for sexual discrimination in salaries against the TVA. The settlement amount represented back pay and was based on the length of service of the employees. The TVA withheld ordinary income tax from the amount of the settlement, and Burke sought to get a refund of that tax under section 104(a)(2). The District Court found for the gov't and the Court of Appeal for the Sixth Circuit reversed.

3. Statutes/Regulations: Section 104 and Regs 1.104.

4. Issue: Whether a payment received in a settlement of a backpay claim under Title VII of the Civil Rights Act of 1964 is excludable from the recipient's gross income under section 104(a)(2) of the IRC as "damages received... on account of personal injuries."

5. Holding: No.

6. Reasoning: The court stated that in order to come within the section 104(a)(2) income exclusion, the legal basis for the recovery of backpay must be a tort-like personal injury. Looking at common-law tort principles as well as other Civil Rights Act statutes which provided broad recovery options including punitive damages, the Court stated that test for whether an award of damages was a tort-type recovery for "personal injuries" turned on whether the remedies available were in keeping with the broad common-law recoveries. Title VII does not allow awards for compensatory or punitive damages; instead it limits available remedies to back pay, injunctions and other equitable relief. Nothing in the remedial scheme of Title VII purports to compensate the injured victim for any of the other traditional tort harms. Thus, since Congress had only decided to recompense Title VII plaintiffs for back wages, which would have been taxable if paid normally, then the exclusion of section 104(a)(2) would be limited as being not applicable to Title VII recoveries. The concurrence [Scalia] went as far as to say that the "tort rights" formulation in the Regs 1.104 goes beyond reasonable interpretation of the statute because it does not limit itself to physical or mental injuries to the taxpayer.

7. Notes: A. Damages received for deprivation of constitutional rights have been held to be excludable under 104(a)(2) because actions to enforce such rights are analogous to torts. However, damages awarded with respect to breach of contract are not excludable. Burke, however, requires further examination of the remedies available to determine if the exclusion applies. Where a settlement which represents tort damages and contract damages has been paid as one lump sum, the IRS requires that an apportionment be made into taxable and non-taxable components. Where no formal basis exists for making the determination, the payor's "intent" is controlling. B. The 1991 amended version of the Title VII now provides for tax-free damages under Burke. C. Punitive damages awarded in tort cases were addressed by Congress in 1989 in amending section 104 to deny any exclusion in any case not involving "physical injury or physical sickness." Thus, punitive damages for defamation, etc., are clearly no longer excludable. However, in Glenshaw Glass the court stated that punitive damages are not awarded on account of personal injury, but rather according to the degree of fault of the defendant. D. Deferred payments of personal injury settlements are excludable under Aames v. Commissioner even if they include a portion identifiable as interest on the lump sum.

I. Annuities - in general, each payment on an annuity are divided into return of capital and income based on an "exclusion ratio" of Sec.72(b) equal to the (investment in the contract)/(expected return under the contract) with all payments made after the expected lifetime of the annuitant being taxable as a "mortality gain" and all portions of the unreturned capital deductible as a "mortality loss" if the annuitant dies before his expected lifetime.

A. Deferred Annuities
1. If the payments do not start immediately, interest that is paid on the taxpayer's investment between the time of paying the premium and the first payment is tax deferred but not treated as the taxpayer's investment in the contract for Sec.72(b) purposes.
2. Cash withdrawals (including policy loans) before the annuity begins paying are taxed as interest income first and treated as return of capital only after all interest on the annuity has been withdrawn.
3. Sec.72(e)(2)(B) provides that the owner of an annuity who transfers the contract for less than adequate consideration realizes income equal to the excess of the cash surrender value over the taxpayer's investment. This prevents a donor from shifting large tax-deferred benefits to a donee.

B. Wrap-around annuities
1. Permits the contract owner to designate the investments into which the premium payments were to be made by the insurance company. "Investment annuities".
2. IRS treats gains from these as currently taxable because the insurance company merely acts as a conduit between the taxpayer and the underlying investments.

C. Policy aspects of deferred annuities
1. Investment income earned on deferred annuities is similar to income on other savings instruments which are not tax deferred.
2. Tax-favored annuities are only available from life-insurance companies, shifting savings away from other financial institutions.
3. Deferred annuities favor those with disposable income available for savings. Thus, it favors the wealthy.

II. Life Insurance - in general, the amounts paid under a life insurance contract are excludable from the beneficiary's income by Sec.101, and all gains to the insured are deferred until the policy is surrendered for cash, in which case the insured may deduct the various fees charged by the insurance company upon surrender.

A. Definition of insurance
1. Some policies called "universal life" mix in a nominal amount of life insurance with a primary savings vehicle to try to obtain tax-deferred status.
2. Sec.7702 defines life insurance in a way that limits the extent to which policies may emphasize savings features by limiting the cash value accumulation.

B. Tax policy aspects
1. The annual increase in the cash value of a life insurance policy during the insured's life represents an increase in the policyholder's net worth which is readily accessible and in fairness should be taxed currently.
2. The non-tax policy objective of providing for protection for families dependent upon a primary breadwinner's income could be accomplished by exempting only the mortality gain with respect to the pure insurance portion of the contract, and not the investment portion of the contract.
3. The tax-deferred status of life insurance contracts diverts money from other savings vehicles and is available only to those with high incomes who can afford the premiums.

** United States v. Kirby Lumber Co., (1931)

2. Facts: Kirby lumber issued its own bonds in 1923, for which it received par value. Later in the same year, it bought back some of the bonds on the open market at less than par, the difference being $137,521.

3. Statutes/Regulations: Predecessor to 61(a) and the accompanying Regs.

4. Issue: Whether a company who buys back some of its own bonds at less than par value has realized income.

5. Holding: Yes.

6. Reasoning: The court reasoned that since the statute included "gains or profits and income derived from any source whatever", that the reduction of debt owed by the company was a gain. Deferring to the Regs, which covered exactly this type of situation, the court concluded that the purchase by a company of its own bonds at a price less than face value is a gain because it frees the company's assets from the from the obligations of debt.

7. Notes: A. In Comm. v. Rail Joint Co., the corporation issued dividends as bonds, but then bought them back for less than face value. The court held that in applying Kirby Lumber, "the consideration received for the obligation evidenced by the bond as well as the consideration paid to satisfy that obligation must be looked to in order to determine whether gain or loss is realized when [the bonds are repurchased]." The Rail Joint Co. did not have discharge of indebtedness income on retirement of its bonds because the corporation did not receive an increment to its assets at the time the bonds were issued. Viewing the transaction as a whole, the corporation received no asset which it did not possess prior to issuing the bonds. B. Sec.108 excludes income from discharge of indebtedness realized in a bankruptcy case or by a taxpayer who is insolvent, as well as certain indebtedness incurred in farming. However, the exclusion is more of a deferral because it requires the taxpayer to reduce any other loss carryovers or his basis in property. Cancellation of indebtedness income is realized to the extent that the taxpayer's assets exceed liabilities after the cancellation. Thus, the taxpayer must be insolvent regardless of the cancellation. There is no good policy reason why cancellation of debt to an insolvent person is tax exempt while income derived from other sources is taxable. In Hirsch v. Comm., the taxpayer assumed a loan on a house and later offered to short sell it to the mortgage company. The mortgage company refused, but reduced the mortgage by $7,000. The court held that the reduction was not taxable until the property was sold because it was a credit to the property itself. However, Sec.108(e)(5) limits this to negotiations between the purchaser and the seller and not third parties. Sec.108(e)(2) provides that no discharge of indebtedness income is realized from the cancellation of a debt that would have been deductible if paid [simple elimination of accounting].

** Zarin v. Commissioner, (1990)

2. Facts: Zarin was a high-roller gambler who played craps. He wrote Resort's Casino some personal checks as markers to establish a line of credit. He was given gambling chips to gamble with based on the amount of money left on his credit line. Eventually, the state of New Jersey cracked down on the lines of credit being extended to Zarin, but the Resort's casino ignored the law and continued to extend Zarin credit. By 1980, Zarin had $3,435,000 of gambling debts owed to Resort's. Zarin denied liability for the debts based on violation of state law intended to protect compulsive gamblers. Resort's casino and Zarin settled for $500,000. The Commissioner argued that Zarin had recognized $2,935,000 of income in 1981 for the cancellation of debt.

3. Statutes/Regulations: 61(a)(12) and 108.

4. Issue: Whether the reduction of an unenforceable gambling debt is income to the debtor.

5. Holding: No.

6. Reasoning: The court stated that Sec.108(d)(1) has a two pronged test for determining whether cancellation of a debt is includable. The taxpayer must be liable for the debt or must hold property subject to a debt. The court reasoned that since the debt was unenforceable by law, that it failed the "liability" prong. Also, since the gambling chips were not technically the "property" of either the casino or Zarin, but merely evidence of a debt that the casino owes the holder, that the debt failed the "property" prong of the test. They viewed the gambling debt as a contested liability. Under that doctrine, when the taxpayer has a good faith dispute with the creditor over the amount of the debt, then the settlement is accepted by the commissioner as the amount of the debt and there is no gain to the debtor if the settlement is less than the face value according to the creditor. They analogized to Sobel [where a disputed bank debt on stock was settled].

7. Dissent: The dissent reasoned that the gambling chips were issued directly as a matter of convenience, and thus did represent the purchase of what the Resort was selling - entertainment and the potential for winnings. Thus, even though he made this purchase on credit, it was still a purchase. When he settled, Zarin's assets were freed of his potential liability for the full amount of the debt.

I. Tax Expenditures

A. A Tax Expenditure is a reduction in individual tax liability that results from special tax provisions or regulations that provide tax benefits to particular taxpayers. They include exclusions, credits, deductions, preferential tax rates, or deferrals.
1. Typically these are mechanisms that promote some desired activity or relieve personal hardship. They can be analogized to direct outlay
programs because the accomplish the same policy objectives. 2. They represent the amount of revenue lost by the government by providing these special tax treatments.

B. Interest on State and Local Bonds
1. As a matter of income tax policy, the interest on gov't obligations should be included in gross income, however, it is excluded by Sec.103(a)(1).
2. The exclusion makes a subsidy by attracting investors with tax-free investments, however, the subsidy is inefficient and unfair.
a. As the tax-free rate increases to attract lower income tax bracket investors, the higher bracket investors receive a windfall.
b. This means that the subsidy is diluted by the windfall to the upper bracket taxpayers.

I. "Trade or Business" versus "Profit Seeking" Expenses

A. Sec.162(a) allows a deduction for the "ordinary and necessary" expenses of "carrying on any trade or business."
1. Does not include an personal deductions for living expenses.
2. Deductible directly from gross income by individuals.
3. In Comm. v. Groetzinger, the court defined a trade or business as being involved "in the activity with continuity and regularity...[and the] primary purpose for engaging in the activity must be for income or profit."
a. Part-time law practice on the weekends for experience and small fees is not a trade or business.
b. Leasing a property to a single tenant with minimal effort for a long time may not be a trade or business.
c. Holding real estate for speculation is not a trade or business (but is a profit seeking activity under Sec.212).

B. Sec.212 allows a deduction for expenses of managing and conserving income producing property, as well as expenses for the production of income.
1. Ex: cost of investment advice or renting of a safe deposit box.
2. Counter-Ex: cost of writing a will is not deductible.
3. Deductible from adjusted gross income as an itemized deduction.
4. Limited by Sec.67 which limits the total amount of "miscellaneous deductions" to the amount by which the total of such exceeds 2% of the taxpayer's "adjusted gross income."

C. In policy, there is no justification for treating business deductions separately from investment expenses.

** Friedman v. Delaney, (1948)

2. Facts: Friedman was a Boston lawyer who had a valuable client named Wax. Wax hired Friedman in bankruptcy proceedings. In negotiating with Wax's creditors, Friedman told them that he personally assured them that enough money to cover the proposed bankruptcy composition would be available. Friedman made this promise based on the belief that he would get the proceeds from a life insurance policy on Wax. When the proceeds were unavailable, Friedman deposited slightly over $5,000 of his own money into the composition, which later failed. The money was lost when Friedman agreed to relinquish any claim to the $5,000 in a settlement, and Friedman claimed the loss as an ordinary and necessary expense of doing business as a lawyer, because he was required to keep his word to the creditors.

3. Statutes/Regulations: Predecessor of 162(a) and 165(a) and (c)(1).

4. Issue: Are funds lost through the voluntary underwriting of the debt of another deductible to a lawyer as a business expense?

5. Holding: No.

6. Reasoning: The majority reasoned that even if Friedman were to have benefited in his professional reputation, that voluntary payments are not deductible as ordinary and necessary business expenses. Those deductions are limited to those "such as are directly connected with and proximately resulting from carrying" on a business, "normally originating in a liability created in the course of its operation." They reasoned that this was an "extra-professional liability." The concurrence stated that although perhaps the statute was broad enough to encompass the deposit of the funds into the bankruptcy composition, when Friedman voluntarily relinquished any claim to the money to induce a compromise settlement of the estate against the trust company, that was not part of Friedman's business.

7. Notes: A. In Welch v. Helvering, the Supreme Court held that the payments of the debts of a failed corporation by that corporation's former secretary in order to reestablish relationships with former customers was not an "ordinary" business expense, even if it were "necessary." What is "ordinary" is a question of fact based on common business experience. In Comm. v. Tellier, the court explained the distinction of "ordinary" expenses as the distinction between whether those expenses are currently deductible, or if they are in the nature of capital expenditures, which, if deductible at all, must be amortized over the useful life of the asset. If this is correct, then "ordinary" does not contrast with unusual, but rather is a word that encompasses capital expenditures and personal rather than business expenditures. "Necessary" imposes only the minimal requirement that an expense be appropriate and helpful to the taxpayer's business. B. Sometimes the "ordinary" language is used to disallow deductions based on unusual business judgment. See, E.g., Trebilcock v. Comm. (employing a minister to give business advice is not deductible). An employee is "engaged in the business of earning his pay" so he may deduct unreimbursed expenses so long as he did not have the entitlement to seek reimbusement.

** Harolds Club v. Commissioner, (1965)

2. Facts: The taxpayer is a casino who employed the father of its principle shareholders. The casino paid the father a salary of between $350,000 and $500,000 for the years in question. The salary was comprised of a fixed amount of compensation, plus an amount representing corporate profits. The casino deducted the entire amount as a business expense, and the Commissioner disallowed a portion of the salary deductions on the ground that the salary was unreasonable. The Tax Court found for the Commissioner on the grounds that the salary was not the result of a "free bargain" because of the family relationships involved.

3. Statutes/Regulations: Section 162(a)(1) and Regs 1.162-7(b)(1)

4. Issue: Are payments of this kind under these circumstances "unreasonable"?

5. Holding: Yes.

6. Reasoning: The court rejected the petitioner's argument that they must be reasonable because in making these payments as cash instead of property or dividends to a person in such an accelerated tax bracket, the corporation could only deduct at a lesser rate than the individual had to pay, thus there was a net loss to the company in tax benefit because of "double taxing" of the funds. They also rejected the petitioner's argument that this statutory interpretation has the practical effect of regulating salary caps, and that Congress intended no such regulatory effect. The court stated that such regulation was "unavoidably incident" to the necessary requirements of the tax scheme of business deductions.

7. Notes: A. In general, the "unreasonable" character of the compensation is usually used to disallow those which are actually disguised payment of dividends or property. However, Harold's Club treats "reasonable compensation" as a separate limitation, applicable whether or not the alleged salary could be recharacterized as something else. Examples of disallowed deductions include schemes whereby bonuses are paid to officer-shareholders based on dividing up available funds or profits as a way to disguise distribution of profits. B. In Smith v. Manning, the daughters of a storeowner filed for a refund of taxes that they paid on what had been disallowed as a deduction by their father of "unreasonable compensation." The daughters argued that any amount in excess of the reasonable compensation was a gift. However, the Tax court refused because of lack of donative intent. Thus "compensation remains compensation even if it is held unreasonable in amount and accordingly not deductible as a business expense." Sterno Sales Corp. v. U.S..

** Rev. Rul. 83-3, (1983)

2. Facts: Situation 1: A veteran lawyer was required by his employer as a condition of continued employment to take certain advanced law classes. The VA gave him $780 total as a tax-free reimbursement for the classes which cost $1054. The VA benefits were intended to be split equally between subsistence and educational costs. The veteran excluded the entire amount of the VA benefit from income, and then deducted the entire amount of the class as a business expense. Situation 3: Same as situation 1, except the taxpayer is not a veteran and the $780 qualified as an excludable scholarship under Sec.117.

3. Statutes/Regulations: Sec.265(a)(1) and Regs 1.265-1(c).

4. Issue: Are otherwise allowable business expense deductions which are paid for by tax-free excludable income disallowed to the extent that they can be allocated to the tax-free income?

5. Holding: Yes.

6. Reasoning: The treasury reasoned that based on U.S. v. Skelly Oil, the IRC should not be interpreted to allow the practical equivalence of double deductions absent clear declaration of intent by Congress. Permitting a full deduction of the business expense in this situation, where at least part of the expenses could be directly allocable to tax- free income, would result in a double benefit not allowed under Sec.265. Thus, the deduction is reduced by the amount attributable to tax-free educational benefits ($390 in Situation 1, and $780 in situation 2).

7. Notes: A. Rev. Rul. 87-102 disallows deductions for payments to obtain tax exempt income (taxpayer who paid legal fees to obtain social security benefits which put her over the limit of non-taxable benefits, exposing her to tax on half of the benefits, could not deduct the entire amount of the legal fees to get below the threshold again, but could only deduct half of the fees.) Sec.265(a)(1) is limited with respect to tax-exempt income and disallows only those deductions which would otherwise be allowable under Sec.212. B. Sec.264(a)(1) operates similarly to Sec.265 be disallowing deductions for payment of life insurance premiums to the extent that the payor is a beneficiary because under Sec.101(a), the proceeds from a life insurance policy are excludable.

** True v. United States, (1990)

2. Facts: True deducted a civil penalty assessed under the Federal Water Pollution Control Act (FWPCA) under Sec.162(a) as an ordinary or necessary business expense. The FWPCA statute assessed fines of $5,000 per violation for spilling of oil into the water. Sec.162(f) contains a disallowance for deductions of "any fine or similar penalty paid to a government for the violation of any law." Regs Sec.1.162-21 interpret that code section as being applicable to fines assessed against a company with respect to the discharge of oil in violation of statute.

3. Statutes/Regulations: Sec.162(a) and (f)

4. Issue: Are the Regulations 1.162-21 unreasonable and plainly inconsistent with the statute (IRC 162) based on the inclusion of an example of oil discharge fines being disallowable?

5. Holding: No.

6. Reasoning: The court looked to the legislative history to determine the scope of Sec.162. A committee comment clarifying the meaning of "fine or similar penalty" stated that it was the intention to disallow deductions for payments of fines under civil statutes which served the same purpose as criminal fines. However, it was not intended to apply to charges and fines that were compensatory in nature and designed to induce prompt compliance with the statute. The argued that the FWPCA fine was primarily compensatory and not punitive. The court found that it was primarily punitive. Thus, the example was reasonable and the Regs were reasonable and consistent with the statute. The allowance of a deduction would violate public policy be reducing the impact of the fine.

7. Notes: A. Deductions are allowed for business expenses incurred in illegal activities unless expressly disallowed by statute. The tax law is not concerned with whether the net income is derived from lawful or unlawful enterprises, it is only concerned with tax. The amounts paid to fraud and theft victims have been held to be non-deductible. C. Sec.162(g) denies the deduction for two-thirds of a treble damages award under a Clayton Act anti-trust suit if the taxpayer has been convicted or plead guilty to criminal charges. D. Sec.162(c) disallows deductions for illegal bribes or kickbacks to government officials and others where the bribe or kickback is in violation of a generally enforced law. E. Sec.165 covers "common law frustration of public policy doctrine" disallowing deductions that may not be expressly disallowed.

I. Lobbying Activities

A. In Camarrano (1959), the court held that generally, business deductions are not available for contributions to political lobbying efforts to support or oppose pending legislation because the deduction would not be available to the independent citizen (since he is not a business).

B. Statutory response
1. The predecessor to 162(e) allowed deductions for lobbying activities, but not advertisement in an attempt to influence the public.
2. For deficit reduction the 1993 legislation significantly tightened making most lobbying expenses non-deductible.
a. influencing federal or state legislation
b. participating in any political campaign
c. attempting to influence the public
d. direct communication with high-level executive gov't officials.

II. Other Tax Penalties
A. Golden Parachute Contracts
1. Payments made to top executives in takeover or acquisitions are non- deductible if they are excessive under Sec.280G because they are essentially trying to redistribute profits or capital costs among the top executives to discourage hostile takeover.
a. excessive is defined as payments that have a present value over 3x the average salary of the executive over the last five years unless clearly evidenced as reasonable compensation for services rendered.
b. However, payments which barely skirt this limit may be disallowed as well.
2. The recipient is subject to a non-deductible 20% excise tax on the amount of the payment.

B. One million dollar limit on fixed compensation deduction under Sec.162(m).

** Moss v. Commissioner, (1985)

2. Facts: Moss is a partner in a Chicago law firm. The partners meet every day at lunch to go over their cases at a relatively modest restaurant that is local to the firm as well as the courthouse. The partners meet at lunch because it is convenient for them to do so during the court recess, but they could also meet at another time, and not have food. Generally, clients are not invited to the lunches - they are working lunches for the partners. Moss deducted the cost of the meals as an ordinary and necessary business expense.

3. Statutes/Regulations: This was before section 274(n) was enacted. Section 262 and accompanying Regs 1.262.

4. Issue: Whether working lunches which are paid for by the partner in a law firm are deductible from that partner's income tax when the circumstances surrounding the lunch indicate that the partners would have paid the same amount for lunch anyway?

5. Holding: No.

6. Reasoning: The court reasoned that this was an issue of mixing business expense and personal expense. Theoretically, the taxpayer should only be able to deduct the excess of the cost to him over the value he actually received from the meal. However, since that was administratively unfeasible, the general rule announced by Sutter stated that the taxpayer was permitted to deduct the whole price provided the expense was different in form, or in excess of what which would have been made for the taxpayer's personal purposes. Although it is undeniable that taking a business client to lunch is a necessary business expense because it reduces other miscommunication problems, things are different when all the participants are coworkers. Since Moss did not claim that he incurred a greater lunch expense at this relatively inexpensive restaurant than he would have otherwise, and the meeting was generally for partners and not clients, it did not serve to accomplish the same business objectives contemplated by Sutter. Also, there was no accounting as to what part of the meal price could have been deemed rent.

7. Notes: A. In general, the value of a meal has both personal and business components. The was to reconcile the two is to require the entire value of the meal to be included in income, and allow a deduction for the amount by which the cost of the meal exceeds the personal value of the meal to the taxpayer. Due to administrative difficulties, section 274(n) arbitrarily limits the deduction for business meals and entertainment to 50% of the expense, treating the personal benefit as one half of the cost. B. As the court noted in Moss, "it is all a matter of degree and circumstance."

I. Section 274 DISALLOWS deductions.

A. General structure- If an expense is otherwise deductible under section 162 or 212, this section must be consulted to see if it has been expressly disallowed.
1. Section 274(a)(1)(A) denies the deduction for entertainment expenses unless they are either:
a. "directly related" to the taxpayer's business; or
b. "associated with" the taxpayer's business - meaning directly preceding or following a bona-fide business discussion.
2. Section 274(a)(1)(B) disallows deductions for entertainment "facilities" such as yachts, hunting lodges, or athletic clubs.
3. Section 274(b) limits the donor's deduction to $25/year per person for business gifts.
4. Section 274(c) requires allocation of all travel costs for foreign travel as between personal and business costs.
5. Section 274(d) imposes rigorous substantiation requirements for deductions of meals and entertainment expenses.

B. Entertainment "directly related" or "associated with"
1. "Entertainment" is broadly and objectively defined under Regs 1.274- 2(b) as "any activity which is of a type generally considered to constitute entertainment."
2. An activity may be disallowed under the "directly related" test because even though it is "motivated primarily by business considerations" it may still provide a goodwill benefit.
3. Taxpayer's own meals and entertainment
a. the judicial rule in Sutter is the broadest, asserting that the taxpayer must overcome the presumption of nondeductibility only by "clear and detailed evidence" that the expense was "different from or in excess of that which would have been made for the taxpayer's personal purposes."
b. The IRS Regs 274(n) provide a compromise, allowing a 50% deduction. c. The practical application is that the IRS applies this rule only to cases of abuse where the taxpayer has claimed deductions for substantial amounts of personal living expenses.

C. Entertainment facilities deductions are completely disallowed by section 274(a)(1)(B).
1. "Facilities" have been distinguished from "activities" in that the taxpayer has exclusive use of "facilities", and not of "activities."
2. "Any use of the facility, no matter how small, in connection with entertainment is fatal to the claimed deduction."

D. Substantiation requirements - generally speaking, the taxpayer must keep "adequate records" or "sufficient evidence corroborating his own statement."
1. An accurate daily log or diary will suffice, unless the expenditure is for more than $25, in which case receipts or bills are required as documentary evidence.
2. Corroborating evidence, such as guest's testimony, must be provided if the only evidence is the taxpayer's statement.

E. Business gifts
1. Section 274(b) is a "second best" solution to the problem of exclusion by the donee and deduction by the donor by limiting the donor's deduction to $25/year per person.

** Commissioner v. Flowers, (1946)

2. Facts: The taxpayer, an attorney, resided in Jackson, MS. He worked as general counsel for the GM&O Railroad. The main office of the railroad was in Mobile, about 200-300 miles away, and so the taxpayer was required to travel between Jackson and Mobile 30-40 times per year in 1939 and 1940. The trips normally took 11 hours, and the taxpayer split his time between the two cities. He claimed a business deduction for the cost of the trips.

3. Statutes/Regulations: The predecessors of 162(a) (business deductions), 262 (disallowing personal deductions), and Regs. 1-162(a).

4. Issue: Whether the statute authorizing the deduction of "traveling expenses...while away from home in the pursuit of a trade or business" authorizes traveling expense deductions where the taxpayer's residence is not reasonably close to his place of business.

5. Holding: No.

6. Reasoning: The court stated that there were three conditions that must be satisfied in order to claim a deduction under the statute: 1) the expense must be reasonable and necessary, 2) the expense must be incurred "while away from home", and 3) the expense must be incurred in the pursuit of business." Skirting the issue of whether "home" was defined as the place of business or the place of residence, they decided that the expense was not incurred in the "pursuit of business." Clearly, the cost of commuting if the office were in Jackson would be a nondeductible personal living expense because it reflected the choice of lifestyle. The court broadened that analysis to make it insignificant whether the taxpayer had one house or two, or whether he traveled 3 blocks or three hundred miles. The railroad did not require him to maintain two houses, nor did they gain any other benefit than the personal satisfaction of the taxpayer.

** Revenue Ruling 90-23, (1990)

2. Issues: 1) Are daily transportation expenses in going between the taxpayer's residence and a temporary work location deductible under 162(a)? 2) Are amounts paid to the taxpayer as reimbursement for such daily travel excludable from the taxpayer's income?

3. Law and Analysis: 1) Section 162 allows a deduction for daily transportation expenses incurred in the taxpayer's business. However, section 262 disallows personal, living or family expenses. To the extent that daily transportation expenses represent the cost of commuting, they are non-deductible personal expenses under 262. However, daily transportation expenses paid in going between two specific business locations are deductible under 162. Thus, for travel between the regular place of business and a temporary place of business, transportation is deductible. 2) Reimbursement for traveling costs are excludable under 62(a)(2)(A) and section 161 so long as they do not exceed the amount of substantiated expenses. Thus, if the employer requires the taxpayer to account for the expenses, and refund any excess, then the reimbursement is excludable under an "accountable plan." Any amounts retained in excess of the amounts substantiated are includable under a "non- accountable plan."

4. Holdings: 1. A taxpayer may deduct such daily travel expenses between two places of work only as a miscellaneous itemized deduction subject to the 2% floor provided in section 67. 2. An employee is required to include in gross income the portion of amounts paid as a reimbursement or other expense allowance for such daily transportation expenses that is treated as paid under a non-accountable plan.

5. Notes: A. Generally, commuting costs can be considered part of a taxpayer's personal expenses because it is assumed that the value of the personal satisfaction from living far from work at least equals the cost of commuting.
2. Once the taxpayer is in "work" status and commuting has ended, local travel expenses are deductible.
3. The nature of the commuting disallowance is not changed by virtue of the commuter carrying certain incidental tools to and from work unless extra costs are incurred.

B. Travel away from home
1. Generally, if the taxpayer satisfies the "away from home test" transportation, meals, and lodging are deductible.
2. Where is the taxpayer's "home"
a. Kroll defined "home" as the principle place of employment - the "tax home."
b. Rosenspan defined "home" in the ordinary sense, relying on the direct business connection test of Flowers to avoid unfair results where the business was far from the residence.
c. Hantzis defined "home" according to a functional test, determining allowance or disallowance of a deduction based on the assessment of the reason for a taxpayer's maintenance of two homes.
3. In Correll "away" from home requires sleep or rest and not merely physical separation from the taxpayer's "home" based on Congress' including "meals and lodging" as a unit to be interpreted together.
4. "Temporary" versus "indefinite" - travel expenses to and from a "temporary" place of work are deductible, but they are not if the place of work is "indefinite."
a. The IRS stated that employment is "temporary" if its termination within a reasonably short time (approx. one year) can be foreseen and if its actual duration does not extend beyond that period.
b. No deductions are allowed for commuting costs even though the distance which the taxpayer lives from work is somewhat involuntary.
5. Where a taxpayer has two places of business, his home is his principle place of business.
6. Where the taxpayer has no principle place of business, (traveling salesman) he can not be "away from home" and so none of his travel costs are deductible.
7. Where there are two workers in a family (husband and wife) each has a principle place of work, regardless of the other.

C. Mixed purpose travel
1. For domestic travel, Regs. 1-162-2(b) provide that the transportation expense is fully deductible if the primary purpose was business, and wholly non-deductible if the primary purpose was pleasure. However, meals and lodging can still be deducted as long as attributable to business purposes.
2. If a trip outside the U.S. exceed 7 days, and there is no more than 25% pleasure, the costs of travel are deductible.
3. Section 274(m)(3) disallows any deductions for expenses of a spouse or dependent accompanying the taxpayer on a business trip unless their expenses are independently deductible.

D. The cost of attending business conventions and meetings is generally deductible under 162 as away from home expenses unless the convention is characterized as a pleasure trip.

E. Non-reimbursed direct moving expenses are deductible under section 217 if:
1. the new place of work is at least 50 miles away, and
2. the individual is employed at least 39 weeks following the move.

** Pevsner v. Commissioner, (1980)

2. Facts: Pevsner is the manager of a YSL clothing store. As required by her employer, she wears YSL clothing at work and while representing the company. The clothing is very expensive, and as such she did not wear it other than at work because it did not fit her modest lifestyle, although she conceded that some of it would look "nice" as streetwear. Pevsner claimed a deduction for the full value of several articles of general clothing that she purchased at an employee discount.

3. Statutes/Regulations: The interplay between business deductions of 162 and the definition of personal disallowance of deductions in section 262.

4. Issue: Whether the cost of clothes which are required to be purchased and warn as a condition of employment, but which are suitable for general use wear.

5. Holding: No. "[T]he cost of clothing is deductible as a business expense only if: (1) the clothing is of a type specifically required as a condition of employment, (2) it is not adaptable to general usage as ordinary clothing, and (3) it is not so worn."

6. Reasoning: The court agreed with the Commissioner's argument that the deduction should be denied because the clothes were adaptable to general usage and the taxpayer was not prohibited from using them as such, even though she did not actually use them generally. The court rejected the tax court approach that allowed a subjective test based on whether that particular taxpayer felt it proper to use the clothing generally in favor of an objective approach based on what is generally acceptable for ordinary street wear. As a practical matter, the objective test is easier to administrate. Furthermore, it is more fair. Otherwise, two employees with the same clothing complement would have differing tax treatments based on their "socio-economic" level.

** Smith v. Commissioner, (1939)

2. Facts: Mr. and Mrs. Smith both were employed outside the home. They paid a nursemaid to take care of their dependent young child. They claimed a deduction for the full amount of the cost of the nursemaid. The Tax Court refused the deduction.

3. Statutes/Regulations: N/A.

4. Issue: Is the cost of child care a legitimate cost of generating income, or a personal expense?

5. Holding: Personal expense not deductible.

6. Reasoning: The court rejected the petitioner's argument that "but for" the child care the wife could not earn income which was taxable. They reasoned that the wife normally does not charge for child care, so their decision to pay someone was a personal choice. They reasoned that child care fell into the category of things that, although they might provide indirect profit, are primarily personal in nature. Child care was grouped with any payment to an employee who took care of the personal wants of their employers.

7. Notes: A. In 1976, the deduction for child care was turned into a tax credit based on the taxpayer's income. B. IF all or part of child care costs are deemed to be related to the production of income, a deduction from gross income, rather than a tax credit, would be required as a structural matter.

** Dreicer v. United States, (1981)

2. Facts: Dreicer was a traveler who lived primarily off of a family trust. Over several years, he claims that he has sought to become a multi-media personality. He travels extensively, and decided to write a book on dining. The book was a failure, and so he continued to travel and dine with the hopes of writing another book. After 20 years, he wrote another book. This book was not published, however. Dreicer claimed deductions on his 1972 and 1973 tax returns of more than $20,000 for travel and business expenses. The Tax Court rejected Dreicer's characterization as a seeker of multi-media fame, and rather characterized him as a writer, thus his activities were not for-profit because he did not have a bona-fide expectation of making a profit.

3. Statutes/Regulations: Section 162, 165 and 183 and related Regs.

4. Issue: Whether the test for whether a taxpayer engages in an activity for profit requires that he have an "expectation" of making profit, or an "objective" of making profit.

5. Holding: A taxpayer engages in an activity for profit, within the meaning of section 183 and the implementing regulations, when profit is actually and honestly his objective though the prospect of achieving it may seem dim.

6. Reasoning: The court reasoned that although they agreed with the Tax Court's finding that Dreicer was a writer-lecturer and not a budding media personality, they applied the wrong standard to determine whether his activities were profit seeking as a matter of law. In looking at the legislative history, it was clear that Congress did not want to penalize a person who persevered through difficult times in an effort to eventually make a profit, simply because the chance of making a profit was slim. Thus, the key was whether the taxpayer engaged in the activity with the objective of making a profit. They did not pass of the merits of this case, but remanded.

7. Notes: A. Upon remand, the Tax Court stated that their use of the words "bona fide expectation" were meant to mean the same thing as an "objective" of making profit, and that Dreicer's activities were properly categorized under that test as pleasure and not profit seeking, particularly because they were losses to offset another source of income. In Churchman v. Commissioner, an artist was held to have a profit seeking objective, even though she enjoyed her "inherently recreational" work, because she conducted her painting sales in a business-like manner. How the scope of the activity is defined is important. If a horse-breeder fails to make a profit on his breeding activities, but defines the scope of his activity as including the land which could be later sold for a profit, then the two activities could be treated as one and thus section 183 disallowances would not apply. B. Tax shelters, popular in the 1970's and 1980's, involved throwing money away into poor investments. However, the after-tax benefit of these shelters may be enough to generate a profit. Thus, the Regs section 1.183-2 are generally applicable to determine whether a profit motive exists whenever trade or business deductions are claimed.

I. Business use of residence - limited by section 280A.

A. Although 280A(a) generally denies all deductions for use of a taxpayer's residence as an office, the following exceptions are made in section 280A(c):
1. the taxpayer's "principle place of business" for conducting any trade or business; or
2. the place which is used by the taxpayer for meetings with patients or clients.
3. If an employee, these must be for the convenience of the employer.

B. "Regular" use is required - occasional visits are not satisfactory.

C. The allowance only applies to "trade or business" uses of 162, not for-profit uses such as a room used exclusively for investment management under 212, even when those investments are the principle source of income of the taxpayer.

D. Principle place of business.
1. In Soliman v. Commissioner, the Supreme Court stated that the primary factual considerations in deciding whether a home office is a taxpayer's principle place of business are:
a. the relative importance of the activities performed at each business location, and
b. the time spent at each place.
2. The point where goods and services are delivered must be given great weight.
3. Whether the functions performed are necessary is relevant but not conclusive.

E. There must be an in-person appearance of clients, telephone calls in the evening do not suffice.

F. Deduction of use for mixed use homes between personal and business use is done on a relative square footage basis.

I. Nondeductible Capital Expenditures

A. Deductibility of an item classified as a capital expenditure, rather than a cost of producing current income, is a matter of timing.
1. Return of capital upon disposition of property is recoverable as basis.
a. Items that are capitalized and added to the basis of an asset under section 1012 may reduce capital gains or create a capital loss when the asset is sold.
b. Deduction of capital losses is limited to the taxpayer's capital gains (plus $3,000 for individuals) under section 1211.
2. Some capital costs are recoverable through depreciation, amortization, or other cost recovery deductions.

B. The "uniform capitalization rules" of section 263A
1. Requires capitalization of "direct" and "indirect" expenditures incurred in connection with inventory and tangible personal property for use in the taxpayer's business.
a. Enacted primarily to deal with "indirect" expenses such as interest, real estate taxes and depreciation.

II. Expenditures to acquire property

A. In general
1. Expenditures which create or add to the value of assets should not be deductible because the simply transform cash into capital.
2. Most profit seeking expenses have at least some de minimis future benefit and thus have a capital component.
a. Regs 1-162-3 provide that the cost of incidental materials and supplies are presently deductible even though they will not be consumed immediately.
b. Regs 1-162-6 permit present deduction for books, furniture, and professional equipment with a short useful life.

B. Expenses connected with the acquisition and disposition of property
1. In Woodward v. Comm. the majority of shareholders of a corporation were required to buy out the shares of a minority, and incurred legal expenses which were not presently deductible under 212 as "ordinary and necessary" investment management expenses because the "origin of the claim" was in the acquisition of stock. Thus, they fees were capitalized into the basis of the stock.
2. In Estate of Baier v. Comm. legal fees incurred in the enforcement of an employment contract providing for the payment of a percentage of royalties on a patent were held to be capitalized into the basis of the patent.

C. Defense or protection of title
1. Origin of the claim test
a. Litigation and related expenses to defend or perfect title to property are capital expenditures under 1.212-1(k) and 1.263(a)-2(c).
b. In Boagni v. Comm., the Tax Court stated that whether the origin of a claim was in the defense or protection of title is a question of fact that requires examination of all the circumstances as a whole.
1) legal fees incurred in connection with a declaratory judgment proceeding disputing title to mineral royalty interests were capital in nature.
2) Fees incurred to determine who was entitled to income from the royalty interests were presently deductible because the income in dispute would be taxable, and it did not involve title to the property itself.
c. legal fees incurred by a stockbroker to defend his license were capital.
d. legal fees in the defense of a real estate fraud case were capital.
e. legal fees incurred in a suit for specific performance were capital.
2. Defense of title vs. recovery of property.
a. In Nickell v. Comm. the court held that although the origin of the claim was in defense of title to stock, the portion of the taxpayer's expenses allocable to recovery of dividend income on that stock was currently deductible under Regs 1.212-1(k).
b. In Cruttenden v. Comm. the court held that since there was no question of the taxpayer's title to the securities, the legal fees were not incurred in the defense or protection of title; expenses for recovery of possession of property were found to be deductible.
3. It really should not matter if the expense was incurred to defend title, or simply to recover possession because in neither case is value added to the property. In both cases, the expenditure is incurred to protect a source of gain to be realized in the future.

** Indopco, Inc. v. Commissioner, (1992)

2. Facts: National Starch (INDOPCO) was being acquired by one of its customers, Unilever. Under Delaware law (INDOPCO was a Delaware corp.), a fairness assessment was necessary to determine the fair value of the shares to be bought from National Starch's shareholders. National Starch hired an investment banker, a legal firm and incurred miscellaneous other expenses in preparation for the transaction. On their final tax return, they claimed a deduction for the legal and banking expenses for a total of $2 million. The Commissioner claimed the expenses were capital in nature. The Tax court agreed based primarily on the long-term benefits that accrued to National Starch from the Unilever acquisition. The Court of Appeals affirmed.

3. Statutes/Regulations: 162(a), 263(a)(1).

4. Issue: Must an expenditure create or enhance a separate and distinct additional asset, as stated in Lincoln Savings, in order to be classified as a capital expenditure under section 263?

5. Holding: No. Distinctions of what is currently deductible and what is capital in nature is a question of degree, and realization of benefits beyond the year in which the expenditure is incurred is important in determining whether the expenditure is capital in nature.

6. Reasoning: The court rejected the petitioner's argument that a separate asset was required for capital expenditures based on Lincoln Savings. "Lincoln Savings stands for the simple proposition that a taxpayer's expenditure that serves to create or enhance ... a separate and distinct asset should be capitalized under 263. It by no means follows, however, that only expenditures that create or enhance separate and distinct assets are to be capitalized under 263." The presence of a future benefit was also a factor in determining the nature of the expenditure. Since National Starch stood to profit greatly from Unilever's enormous resources, the future benefits were neither "speculative" nor "merely incidental" but rather significant. They stated that the general rule was that expenditures were not deductible, unless a clear statutory provision for their deduction exists. Thus, National Starch failed to demonstrate that the banking, legal and other costs it incurred were deductible.

A. Separate assets vs. future benefit.
1. In Fall River Gas Appliance Co. v. Comm., the court held that "a capital expenditure is one that secures an advantage to the taxpayer which has a life of greater than one year..., and that the taxpayer must acquire something of permanent use or value in his business."
2. Lincoln Savings requires capitalization when the costs create a separate and distinct asset, but if not, Indopco requires an inquiry into whether the expenditure resulted in a future benefit beyond the year the expenses were incurred.
3. in Sun Microsystems, Inc. v. Comm., rebates to customers were allowed to be deducted even though the purpose was to establish a long-term relationship with customers.

B. Business Expansion
1. Indopco presents uncertainty as to whether costs to expand an existing business are presently deductible because they arguably result in a future benefit.

C. Start-Up costs
1. Section 195 allows business start-up costs to be amortized over a five year period if they meet both of the following:
a. the expenditure must be made in connection with the creating or investigation of creation of a business, and
b. it would have been allowable as a business expansion deduction had the business already have been a going concern.
c. These include survey of potential markets, advertising, salaries and wages paid to employees being trained, etc.
2. The election to amortize under 195 is the exclusive means of recovering startup costs prior to a sale or other termination of the business.

D. Prepaid expenditures
1. Prepayment of expenses for items such as taxes, interest, and salaries for benefits to be derived in future tax years must be capitalized.
2. Normally, prepaid rents are required to be amortized of the period they represent.
E. Advertising expense
1. Advertising costs should be capitalized because they create a future benefit, however, section 1.162-20(a)(2) specifically provides a present deduction for institutional or goodwill advertising "provided that the expenses are related to the patronage."
2. Rev. Rul. 92-80 states that advertising will only be capitalized in the "unusual circumstance", thus expressing an indication that they will not literally read Indopco to all future benefit expenditures.

** Midland Empire Packing Co. v. Commissioner, (1950)

2. Facts: Midland owned and operated a meat packing plant. It stored meats in the basement for curing purposes. Occasionally, water seeped into the basement, but it was not a problem. In the taxable year, oil from a neighboring refinery also seeped in through the groundwater, causing a fire hazard and causing the Federal meat inspectors to order oilproofing of the basement in order to avoid shutting down of the plant. Midland claimed the cost of oilproofing the basement as an ordinary and necessary business expense under section 162. The Commissioner argued that the oilproofing was more than a maintenance repair and thus should be capitalized.

3. Statutes/Regulations: Regs 1.162-4 and 162(a)

4. Issue: Whether an expenditure to defend against a nuisance which threatens one's business is properly deductible under section 162(a).

5. Holding: Yes.

6. Reasoning: Regs. 1.162-4 differentiated between presently deductible repairs and capital outlays in that the former does not increase the value of the property or increase its life, but merely keeps it in a proper operating condition for its expected life. Capital improvements, on the other hand, either increase the value of the property or prolong its life, and are in the nature of a substitution or replacement instead of a maintenance action. The evidence in this case was that the oilproofing did not prolong the life of the basement, nor did it add value over what things were before the nuisance occurred. They merely kept the basement in proper operating condition for the storage of meat. Citing to Welch v. Helvering, the expenditures were not out of the ordinary just because they were not expected to recur. "The expense is an ordinary one because we know from experience that payments for such a purpose...are the common and accepted means of defense against attack."

I. Depreciation - the cost of exhaustion of the value of a consumed asset, similar to wages in labor.

A. The internal rate of return of a capital investment is the discount rate necessary to make the present value of the cash flow from the capital equal to the investment made. 1. Ideally, capital cost recovery should be allowed at exactly the rate of economic depreciation so that the annual after-tax return from the investment is equivalent to the before-tax return less the tax paid.

B. Depreciable Basis
1. The amount of the cost to be recovered is normally the capitalized cost of the asset minus the salvage value at the end of the useful life.

C. Useful Life
1. In Massey Motors, Inc. v. U.S., the court held that they useful life of property was the useful life to the taxpayer in his particular business, rather than the actual physical life of the property itself. Thus, a rental car's useful life was 15 months, even though the car itself would last for 4 years. This resulted in the taxpayer having to depreciate the car only over 15 months and subtract the resale value as salvage instead of depreciate the entire value of the car over 4 years. 2. Under the Modified Accelerated Cost Recovery System (MACRS), the depreciation schedule for various commodities are standardized to 3, 5, 7, 10, 15, and 20 years, with residential real property of 27.5 years and all other real property 39 years with salvage value not taken into account.

D. Methods of capital recovery
1. Straight line method - does not exactly match economic depreciation.
2. Declining Balance method - provides a larger depreciation in the early years of an asset's useful life than the straight line method, and then smaller deductions in later years.
a. Double declining balance - multiplies the straight line depreciation percentage by 200%, thus, it never allows full recovery of basis.
3. MACRS section 168 adopts the double-declining balance method until the straight line method would yield a larger allowance.
a. The switch to the straight line method allows full recovery of basis in the end. Salvage value is ignored.
b. Real property is depreciated using the straight line method.
c. Section 168(d)(1) and (4) require that the property be treated as being placed into service in the middle of the tax year, allowing only a 1/2 deduction in the first year and the last year.

E. Adjusted basis
1. Section 167(c) provides that depreciation is allowed with respect to the property's basis determined under 1011.
2. Under 1016, the basis is increased for capital expenditures attributable to the property, and decreased by depreciation, resulting in adjusted basis.
3. Basis is reduced statutorily by the full amount of the allowable depreciation, regardless of whether the taxpayer actually claimed the deduction (1016(a)(2)) and the taxpayer can not recover unclaimed deductions at a later date.
4. In contrast, Regs 1.1016-3(a)(1) and (e) provide that if the taxpayer overclaims his deductions, the full amount of the deduction is used to reduce the basis.
5. Mortgage debt is includable in basis.

F. Eligible property
1. Section 167(a) requires that to be eligible for depreciation, the property must be used in trade or business or for the purpose of producing income (162 and 212 uses).
2. In general, mixed use property must have the basis allocated between the personal and the business use, and the depreciation is allowable only on the business portion.
a. Section 280A and 280F limit the deduction available for depreciation of home use computers, automobiles and personal residences used partly for business.
3. Depreciation is only available for property that is consumed through "exhaustion, wear and tear (including a reasonable allowance for obsolescence." Regs. 1.167(a)-2.
a. Costs attributable to improvements made on land are deductible amortized over the life of the structure, however, costs to improve the value of the land itself are not generally deductible because land is not depreciable.
b. The cost of a purchased leasehold is amortized and deducted over the term of the lease.
c. Tangible personal property such as art and antiques is non- depreciable.
d. Inventory is non-depreciable.

G. Modified Accelerated Cost Recovery System (MACRS)
1. Generally, the MACRS depreciation is determined under 167(b) and 168(a) by applying the "applicable depreciation method" to the "applicable recovery period" and taking into account the "applicable convention" for when the property was placed into service. 2. Recovery periods
a. Section 168(c) and (e) classify all tangible property into one of seven recovery periods: 3, 5, 7, 10, 15, 20, 27.5, and 39, based on its midpoint useful life (ADR) as determined by the IRS.
3. Under 168(a)(3) and (d) tangible personal property is treated as being placed into service in the mid-point of the year, unless the taxpayer is buying more than 40 percent of his assets late in the tax year to try to get an advantage.
a. 168(d)(3) requires the use of a mid-quarter convention in some cases to prevent abuse.
b. 168(d)(2) requires real property to be put into service in a mid- month convention.
4. The IRS has provided tables for multiplying the original basis of the property by a tabulated percentage to determine the depreciation allowable.
5. 168(g) provides alternate depreciation systems (straight line as opposed to double declining) for certain property that is used outside of the U.S., financed with tax-free bonds, or leased to a tax-exempt entity.
6. 168(f)(1) allows the taxpayer to elect to depreciate according to a schedule based on something other than time, e.g. miles traveled for rental cars.
7. General asset accounts in the proposed Regs allow the taxpayer to group like assets together for depreciation purposes to avoid having to depreciate each one individually.

II. Section 197 - 15 year amortization of intangible assets

A. In general, Congress enacted 197 to depreciate intangibles without regard to whether the asset was depreciable under 167,
1. allowing the depreciation of goodwill, going concern, and others that were previously non-depreciable.
2. However, other things that were previously depreciable under a short useful life must now be depreciated over 15 years.

B. Amortizable intangibles.
1. Any intangible listed in 197(d) that is acquired by the taxpayer and held for use in the taxpayer's trade or business is subject to the 15 year amortization.
a. includes: goodwill, going concern value, workforce in place, information base assets such as customer lists, know-how including patents and intellectual property, market share, licenses, etc.
2. Section 197(c)(2) limits the 15 year rule to the following self- created assets in order to avoid a taxpayer entering into a license to exploit that intangible for less than 15 years:
a. licenses, franchises, trademarks, contracts for the use of intangibles.
b. patents that are acquired as part of a business purchase are subject to 15 year amortization, regardless of how long is left on the term, but patents that are developed are subject to amortization over the entire statutory term.

C. Excluded intangible assets
1. Section 197(e) excludes certain assets which the taxpayer must established that the asset has a limited useful life or recovery period in order to deduct.
a. financial interests, interests in land, computer software, interests in leases, interests in a debt instrument, professional sports franchises.

D. When a taxpayer sells or otherwise disposes of a section 197 intangible which was acquired at the same time as another intangible which is retained, no loss deduction is allowed under 197(f)(1) to avoid problems of allocating cost among intangibles.

III. Deductions as Tax Expenditures

A. Section 174 allows the deduction of certain research and development costs which would otherwise have to be capitalized.
1. 174(e) limits the amount to reasonable under the circumstances.
2. In Snow v. Comm., the court held that expenditures incurred by a limited partnership in the development of a product which had not yet made any sales were "in connection with" a trade or business for purposes of 174.
3. Deductions are not available for mere passive investors.

B. Pollution control facilities are amortized over 5 years under section 169 as a Congressional policy to spread the cost of pollution reduction over taxpayers instead of to the specific product consumer.

C. 179 allows current deductions up to $17,500 for capital purchases less than $200,000 and then dollar-for-dollar reduction after that up to $217,500, but it is limited to the taxpayer's income for that year (so no loss can result).
1. 179 reduces the adjusted basis of the property that may be recovered through depreciation under MACRS.

I. Deductible Interest - deductibility depends on traceability to proper uses under 1.163-8T

A. Generally, interest is classified with respect to five broad uses:
1. active business interest - deductible under 163;
a. "production period" interest must be capitalized under 263A(f).
2. passive activity business interest - subject to the loss limitation of 469;
a. "production period" interest must be capitalized under 263A(f).
3. taxable investment interest - limited to investment gains under 163(d);
4. tax exempt investment interest - no deduction under 265;
5. personal interest - non-deductible under 163(h).
6. Co-mingling borrowed funds with other funds presents tracing problems:
a. Regs. 1.163-8T(c)(4) allows that expenditures from co-mingled accounts first be allocated to borrowed funds.
b. Regs. 1.163-8T(c)(4)(iii)(B) allows a taxpayer to allocate any expenditure to any funds borrowed within the last 15 days.
c. Regs. 1.163-8T(d) require allocation of funds from the same loan which are used for multiple purposes in the following order:
1) personal expenditures (non-deductible)
2) pro-rata between investment and passive business activities; and finally
3) active business expenditures.

B. Interest paid or incurred in the business of being an employee are non-deductible personal expenses.

C. Interest must be on a debt of the taxpayer, and not paid by the taxpayer on someone else's behalf.

II. Investment Interest Limitation (Section 163(d), Tax Reform Act of 1986)

A. 163(d) was enacted to prevent current deductions of interest on loans used to purchase investment property. Prior to 163(d), an investor could take present deductions on the interest on the loan, even though he had not yet sold the property.

B. 163(d) limits current deductions of investment interest to the amount of net investment income during each year. Interest disallowed is carried forward to succeeding year.
1. This prevents current deductions from exceeding income (resulting in a net loss).
2. This allows the interest deduction to offset any investment income, thus bypassing the stacking rules of 1.163-8T.
3. 163(d) only applies to investment interest, not business interest, in the same way that 212 is distinguished from 162.
a. The test for whether it is business or investment interest is whether the taxpayer had "a substantial investment intent" when the money was borrowed. See Recklitits v. Comm.
4. Special rules apply to the interest on market discount bonds.

III. Below-market interest rate loans

A. Prior to the deficit reduction act of 1984, below market interest rates were used to hide income.
1. An employer could make a below market loan to the employee, and thus avoid paying taxes on the market rate of interest income, as well as the employee not having to include the difference between the interest he was paying and the market interest in his income.

B. Section 7872 treats below market interest loans as:
1. The borrower paid interest to the lender that may be deductible to the borrower and is included in income by the lender at the full market rate; and
2. The lender makes a subsequent "gift" to the borrower amounting to the difference between the actual and market interest rates.

C. This applies to term or demand loans that are gift loans

D. The federal rate is the market rate, and is determined according to 1274(d) as being the average over a 6 month period ending September and March, respectively.
1. There are 3 applicable rates - 0-3 years (short term); 3-9 years (mid-term), and 9+ years (long-term).

E. A de-minimis exception applies under 7872(c)(2) for aggregate amounts of all loans which are less than $10,000.

F. Examples:
1. If a parent loans a child a below market rate, the child is treated as paying the entire amount as interest, which may be deductible depending on the use, the parent is treated as having income at the market rate, and the foregone interest is treated as a gift.
2. If an employer makes a below-market loan to an employee, the employee is treated as paying the market interest rate back to the employer, which is treated as income to the employer, the employer has an offsetting salary deduction for the amount of the foregone interest, and the employee has income in the amount of the foregone interest.
3. For term loans, the compensation is the difference between the actual repayment and the present value of the total repayment at the market rate.

** United States v. Gilmore, (1963)

2. Facts: The taxpayer was the controlling stock owner in 3 GM car dealerships. His wife was suing him for divorce, alleging infidelity, and he counter-claimed for divorce and won. One of the goals of the wife's divorce suit was to get 1/2 of his stock which she claimed was community property. If she would have won, he would have lost his controlling ownership of the dealerships. However, since she lost, she got nothing. The taxpayer spent about $40,000 in legal fees over the 2 year course of the litigation. He deducted it, and the Commissioner refused the deduction, claiming that the legal expenses were personal and not business related under 162. The court of claims found for the taxpayer and the Supreme Court granted the govt's request for review.

3. Statutes/Regulations: 162, 212, 262.

4. Issue: Whether the legal expenses made by the taxpayer in the divorce litigation were properly deductible under 162 or 212.

5. Holding: No. The origin of the claim, rather than its potential consequences, is the controlling test for whether legal expenses are business or personal in nature.

6. Reasoning: The court reasoned that judging the deductibility by the potential consequences to the taxpayer would result in the anomaly of the legal fees for two identical actions being deductible only based on the nature of the assets of the defendants. Such a rule would allow taxpayers to deduct nearly all legal fees, even if clearly of a personal nature, by arguing that such fees helped keep their property free of liens, thus increasing their net worth. In this case, the court concluded that the wife's action originated out of the marriage, and thus the legal fees were personal in nature.

7. Notes: I. Legal Expenses Generally

A. Applications of the "origin" test
1. The origin test serves to distinguish between personal and business legal expenses, as well as between current and capital expenses. Thus, although personal legal expenses may be capitalized even though they are not deductible.
a. In U.S. v. Patrick, the Court denied a deduction for legal expenses in connection with a property settlement agreement made pursuant to an uncontested divorce proceeding.
b. Legal fees incurred to defend against criminal charges or civil disciplinary hearings arising out of the conduct of the taxpayer's trade or business generally are deductible.
c. However, expenses in criminal defense that result in loss of employment are nondeductible if they did not arise from the conduct of the taxpayer's business.
d. Ex: In Tellier v. Comm., a securities dealer was allowed to deduct legal fees in the unsuccessful defense of criminal fraud charges arising out of his work.
e. However, in Barrett v. Comm., the legal fees incurred by a stockbroker to defend an insider trading action that would have suspended his broker's license were required to be capitalized into the basis of the stock.

B. Legal fees incurred to collect income from a nonbusiness profit seeking activity are deductible under 212(1).
C. Legal expenses to defend the title to property must be capitalized under Regs. 1.212-1(k).
1. In the second Gilmore case, the legal expenses disallowed as a current deduction in Gilmore #1, were allowed to be capitalized into the property basis.

II. Tax Matters

A. 212(3) provides a deduction for expenses incurred in connection with the determination, collection, or refund of any tax, and even tax planning (such as the cost of obtaining a private letter ruling.)

B. Expenses for preparing the portion of a tax return relating to the taxpayer's trade or business and to contest tax deficiencies arising from the trade or business are deductible in computing adjusted gross income under 62, but any other expenses relating to the determination of tax liability are deductible only as itemized deductions, and thus subject to the 2% floor of section 63.

** Wassenaar v. Commissioner, (1979)

2. Facts: The taxpayer is a former Law student who worked various odd- jobs before attending law school. He worked on the law review while he was in law school, for which he was paid. One summer in law school he interned. After failing the first bar exam, he passed the second, and then went on to get a master's in taxation law. Finally, he was admitted to the bar and began to practice law. He attempted to deduct the cost of his master's in taxation degree, which was completed before he was admitted to the bar. The commissioner rejected the deduction claiming that it was personal in nature and not an ordinary and necessary expense of conducting a trade or business.

3. Statutes/Regulations: 162, Regs 1.162-5

4. Issue: Are educational expenses incurred before a lawyer is admitted to the bar to practice deductible under 162?

5. Holding: No.

6. Reasoning: The court reasoned that since the taxpayer was not admitted to the bar at the time he incurred his educational expenses, he could not claim that they were ordinary and necessary expenditures. They rejected his argument that he was in the business of being an employee, as being unrelated to his master's degree because he was not practicing law. The court stated that the taxpayer must be established in the trade or business. Additionally, the court stated that his deduction was disallowed under 1.162-5(b)(3) as qualifying him for a new business. Lastly, they rejected his argument that his education assisted him in preparing his tax return and was thus deductible under 212(c). The court stated that to be deductible under 212, the expenses still must be reasonable or ordinary and necessary.

I. Education Expenses

A. Background - prior to 1958, all educational expenses were disallowed as being personal expenses.

B. In 1967, Regs 1.162-5 were enacted applying an objective standard to the deductibility of educational expenses:
1. The education must maintain or improve skills used in the taxpayer's trade or business (or be required by the employer).
2. If the education qualifies the individual for a new trade or business (even in the same field) it is disallowed regardless of whether the taxpayer actually intended to use the education in a new trade or business.

C. Even if the taxpayer has at one time been in a trade or business, the trade or business can be "lost" if it is not pursued for a 1 year period of time (Furner).

D. The education must "maintain or improve skills".
a. The test is whether the course of study is appropriate helpful or needed.
b. In Takahashi v. Comm., the schoolteacher taxpayers were disallowed a deduction for "multi-cultural education" when they took a trip to Hawaii.

E. Expenses incurred in meeting the minimum educational requirements for the trade are nondeductible even if the taxpayer has begun employment.

F. If the education qualifies the taxpayer for a new trade or business, Regs. 1.165-5(b)(3) disallow a deduction for the expenses even though the education is in fact related to the taxpayer's existing business.
1. The cost of a law degree is nondeductible to a tax accountant, even though he wishes to be a tax attorney.
2. The test of whether the education qualifies the taxpayer for a new business is whether there are additional types of activities and tasks that the taxpayer is now qualified to perform that he was not previously.
F. Section 274(m)(2) disallows travel as a form of education.

G. Education expenses generally can not be capitalized, thus they are gone forever if not currently deductible.
1. A taxpayer can not amortize the cost of education over his lifetime even though that has the practical effect of taxing him on more than his lifetime income.

H. Regs 1.212-1(f) provide that expenses incurred in seeking employment or in placing oneself in a position to begin rendering services for compensation are not deductible, unless they involve seeking employment in the business that the taxpayer is already established in.

I. Personal Exemptions

A. The basic personal exemption amount for each individual is set by Sec. 151(d) to $2,000 and is adjusted annually with inflation.

B. Sec. 151(b) grants the basic personal exemption for each taxpayer.
1. spouses who file jointly can claim a personal exemption for both even if one has no income.

C. Sec.151(c) provides for deductions for dependents as defined in Sec. 152.
1. limited to persons with the relationship if Sec. 152(a) for whom the taxpayer provides over 1/2 support.
2. dependent's income must not exceed the amount of the exemption, except in the case of children under 19 or full time students under 24.

D. Sec. 151(d)(2) denies the personal exemption to any taxpayer who is a dependent of another taxpayer entitled to claim a dependency exemption.

E. Policy:
1. If the personal exemption is viewed as defining a tax bracket of zero tax rate, then all taxpayer's should have the personal exemption regardless of their income,
2. However, the current view is that the personal exemption is viewed as a mechanism for exempting a subsistence level, and thus should be phased out as the taxpayer's income increases.
3. Family size could be viewed as a personal consumption choice and thus irrelevant to tax liability,
4. However, the current view is that the family size should be taken into account in the subsistence level.

II. Standard Deductions vs. Itemized deductions -The standard deduction serves to set the level at which positive tax rates begin, as well as a floor which itemized deductions must exceed to be allowable.

A. Itemized deductions and Adjusted Gross Income
1. AGI = gross income - all deductions specified in Sec.62.
2. Remaining deductions are taken into account in computing taxable income under Sec.63.
3. Generally, profit seeking deductions are deductible from gross income, while others are itemized.

B. Amount of standard deduction
1. Sec.63(c)(2) provides a basic standard deduction.
2. Sec.63(c)(1)(B) and (f) provide additional standard deductions for blind and elderly persons.
3. All of the amounts are indexed for inflation under Sec.63(c)(4).

C. Limitations on Itemized deductions
1. Sec.67 allws a deduction for "miscellaneous itemized deductions" only to the amount that the aggregate of such deductions exceeds 2% of the taxpayer's AGI.
a. This has the consequence of treating business deductions (which are deductible from gross income) and profit-seeking deductions (under 212, which are subject to the 2% floor) differently, giving preference to the business deductions.
2. Sec.68 limits the amount of certain itemized deductions for high bracket income taxpayers.
a. When AGI exceeds $100,000, the relevant itemized deductions are reduced by 3% of the amount of the excess.
b. This is an inequitable structure because it results in a marginal rate higher than the maximum specified in section 1.

D. Earned Income Tax Credit - Sec.32
1. Differing amounts based on income and number of qualifying dependent children.
2. Original purpose was to offset the Social Security Tax burden on low- income families, but has become a tax expenditure for welfare-like effects.

** Ochs v. Commissioner, (1952)

2. Facts: The taxpayer's wife had throat cancer. After it was treated, the wife lost most of her voice and could hardly speak above a whisper. A few years after the treatment, it became apparent that the wife was not recovering because she had a large amount of stress to take care of two children, ages 4 and 6. On the advice of a doctor, the taxpayer sent the children to day-school in order to assist in his wife's recovery. The taxpayer claimed the cost of the child-care as medical expenses, and the Commissioner disallowed the deduction, claiming that the expenses were personal and not medical. The tax court sympathized with the taxpayer, but nevertheless held the expenses to be non-deductible.

3. Statutes/Regulations: Section 213 and 262 and regs.

4. Issue: Are expenses for sending children to school in order to separate them from a mother who needs peace and quiet to recover deductible?

5. Holding: No.

6. Reasoning: The court reasoned that although the line between medical and personal expenses was a difficult one to draw, that only reflected the fact that certain personal expenses that directly benefited one member of the family (in this case the kids), also indirectly benefitted other members of the family. The court reasoned that the children's school expenses were made because of a loss of the wife's services, and therefore nondeductible even though the wife also received a benefit.

7. Dissent: The dissent reasoned that according to the congressional history, the term "medical care" should be given a broad reading. The dissent proposed that the test should be the origin of the expense and its primary purpose. It seemed anomalous that if the wife were sent away to a hospital to recover, those expenses would be deductible, but since the children were sent away, the expenses were non-deductible, even though the practical effect and reason for each was the health of the wife. The dissent favored an allocation between the amount of personal benefit and the amount of the medical benefit, claiming that such a rule would not overburden the courts with false claims that could not easily be screened.

I. Medical Expenses Generally

A. Sec. 213(d)(1)(A) defines "medical care" as including amounts paid for the "diagnosis, cure, mitigation, treatment, or prevention of disease" for "the purpose of affecting any structure or function of the body."
1. Regs. 1.213-1(e) provide examples of allowable medical expense deductions.
2. Examples of non-deductible expenses:
a. Ring, spiritual aid at a shrine that did not provide medical advice. b. Brown, marriage counseling
c. cosmetic surgery disallowed under Sec.213(d)(9).
d. Theone, dancing lessons.
3. Expenses incidental to medical care are also deductible such as:
a. legal expenses,
b. transportation, food and lodging under 213(d)(1)(B). and 213(d)(2).
4. Expenses for disabled persons for specialized or modified equipment can be deductible to the extent that they are reasonable and necessary and exceed the normal cost to others, but some must be capitalized and amortized if they improve the value of the property.
5. Subject to a 7.5% of AGI floor.

B. Since the floor is 7.5%, there is a tendency to "bunch" expenses into one year, such as prepaying for medical care.

C. Sec.213 is allowed only for expenses not covered by medical insurance or otherwise reimbursed or covered so it is subject to Sec.Sec.104-106.

D. If expenses are required for special services of an employee (such as a reader for a blind employee), then they are deductible under 162 (and not 213) if:
1. They are clearly necessary to enable the employee to do his work,
2. they clearly not required or used for personal reasons,
3. the code is silent on the particular expense.

I. Charitable contributions Sec.170
A. Must take into account six different factors:
1. The nature of the contribution (cash, services, etc.)
2. The nature of the recipient (the qualification of the charity, 50% deductible or otherwise);
3. the tax attributes of the property (basis would result in income or capital gain);
4. the recipient's use of the property (taxable vs. tax exempt purposes)
5. the legal form of the transfer (trust, sale, lesser interests)
6. substantiation (170(f)(8) requires written receipt from the recipient for $250 or more in donations.)

** Hernandez v. Commissioner, (1989)

2. Facts: Hernandez paid money for Scientology "auditing" and deducted it on his taxes as a charitable contribution. The Scientology church had a fee structure for all of its religious services, and from all appearances, it seemed that a participant was purchasing religious benefit. However, the church qualified as a charitable organization. Both the tax court and the court of appeal denied the deduction on the grounds that the payment of fees for "auditing" was not a donation, but an exchange for consideration.

3. Statutes/Regs.: Sec.170.

4. Issue: Are amounts paid for scientology audits deductible as charitable contributions.

5. Holding: No. For a charitable donation to be deductible it msut be a gift made with no expectation of a financial return commensurate with the amount of the gift.

6. Reasoning: The court reasoned that the nature of the fee schedule promulgated by the church made this a quid-pro-quo transaction. It was immaterial that the benefit was religious instead of economic or secular. Congress had intended only to provide deductions for payments which gave no return of goods or services. The fact that no special reference was made in the code to "religious" benefit as being an exception to the general rule was not an oversight. Furthermore, the court rejected the taxpayer's arguments that Sec.170 violated the establishment or free exercise provisions of the constitution because the statute was religion neutral in design and purpose and did not give one religion preference over another except for the fact that Scientology chose to structure their fundraising efforts in a certain way as opposed to another way. Following Lee, the court stated that an individual religion's practices could not be allowed to determine the structure of the tax code.

7. Dissent: The dissent reasoned that to disallow these deductions would be inconsistent with allowing deductions for prayer breakfast costs, because both contributions included a gift amount as well as a purchase amount. For fairness and administrative ease, Congress had decided to exempt the entire cost of such deductions. They reasoned that there was no distinction between the Scientology charging fees for religious services, and a Christian purchasing a pew rental.

I. Qualified Home Mortgage Interest

A. Under section 163(h)(3), qualified residence interest generally means interest on a debt secured by a security interest in a principle residence or one other residence of the taxpayer.

B. Interest on up to $1M of indebtedness to acquire or improve the taxpayer's principle residence and one other residence is deductible.
1. where the total acquisition and improvement indebtedness exceeds $1M, only the interest on the first $1M is deductible.
2. There are no regs on how to allocate interest between two loans with a sum debt of more than $1M.
3. In determining "principle residence" all surrouding facts will be taken into account.
4. "Second residence" can include boats, recreational vehicles and so forth that have sleeping, eating, cooking and toilet facilities.
5. The taxpayer must have either not rented the second residence, or have occupied it the greater of 14 days or 10% of the rental days in order to claim this deduction.

C. Home equity debt is deductible even if its use is traceable to personal consumption such as autos or vacations.

D. Sec.265 disallows deductions for qualified residences if a home equity loan is used to purchase tax exempt bonds, or if the taxpayer receives a tax exempt housing allowance (double-dipping).

E. Sec.461(g)(2) allows a current deduction for purchase money points, but does not apply to refinance money points.

F. Policy: if the taxpayer is willing to borrow for personal consumption, then the interest reflects the personal value of the consumption to the taxpayer and thus should not be deducted. However, the interest on a home is deductible as a subsidy to promote home ownership.

II. State and Local Taxes

A. Section 164 allows a deduction for certain taxes, including domestic state and local real property, personal property, and income taxes.
1. Sec.275 denies deductions for certain other taxes including federal income taxes.
2. Individuals may deduct non-business taxes only as itemized deductions under Sec.63.
3. Levies that relate to improvements that enhance the value of the assessed property such as sewer or sidewalk assessments are not deductibel taxes.
4. A taxpayer may only deduct taxes that he pays on his own behalf, not those paid for another.

B. Policy
1. Theoretically, all local taxes pay for some benefit that the taxpayer receives. Thus, $50 in local taxes pays for $50 in local benefits.
2. However, in the real world, the taxpayer does not receive the full amount of benefits.
a. states provide benefits to other residents besides the local taxpayers.
b. taxes are based on ability to pay, thus are inherently income- redistributive.
c. taxpayers are not mobile enough to choose a locality that has preferential tax treatment.
3. Thus, even though the taxpayer receives some benefit from the payment of local taxes, the benefit is not practically measureable. So the deduction is allowed in order to avoid over-taxing some taxpayers.
4. Home mortgage interest deductions benefit those most able to buy nicer houses and finance them.

** Pulvers v. Commissioner, (1969)

2. Facts: The taxpayer owned a home at the base of a mountain in LA County. A landslide had destroyed 3 nearby homes, but did not do physical damage to the taxpayer's property. Neither did the landslide destroy the ingress or egress from the property. However, it did have a measureable effect on the market value of the property. The taxpayer tried to claim a current deduction for "other casualty loss" under Sec.165(c)(3) on the reduction in value of the property due to the fear of potential buyers that his house was in danger of damage.

3. Statutes/Regulations: 165

4. Issue: Whether the reduction in value of a property caused by physical damage or reduction in value of surrounding property is deductible under 165 as an "other casualty loss."

5. Holding: No.

6. Reasoning: The court reasoned that a loss of this type was not within the meaning of "other casualty loss" as interpreted in context of the statutory language. The specific inclusion of the words fire, flood, shipwreck and theft, indicated tht "other casualty loss" was to be interpreted as only losses which were like those enumerated. To allow this deduction would open the door for other deductions that affected the value of the property (such as bad neighbors) but did not do damage to the property itself. The loss was unrealized and it is possible that the value would return.

I. Notes:
A. Meaning of "casualty" and theft.
1. The primary characteristic of a casualty which falls under 165(c)(3) is that of the suddenness of the occurrence.
a. It must be due to an "identifiable event," "damaging the property" that was "sudden, unexpected, and unusual."
b. A casualty caused by the taxpayer's own negligence is still deductible as long as it was not willful or gross negligence.
c. property that is merely "lost" but not "stolen" is non-deductible.
d. the casualty loss is limited to the decline in value of the property involved and does not include additional expenses incurred because of the casualty.
2. Theft includes but is not limited to larceny, embezzlement and robbery under 1.165-8(d),
a. only if the taking was criminal under the applicable state law.
b. 165(e) provides that a theft loss is deductible in the year discovered, not necessarily the year of occurrence.

B. Determination of the amount of the casualty loss
1. If the property value exceeds its basis at the time of theft (positive equity):
a. loss is limited to the amount of the adjusted basis. 165(b)
b. claim current deduction for entire amount of the loss, but then reduce the basis by the amount of the deduction. Regs. 1.165-7(b)
2. If the property value is less than the basis (negative equity) a. loss is limited to the fair value of the property.
b. otherwise, a casualty loss could encompass the normal wear and tear that reduced the fair market value below the basis.

C. Reimbursement for loss
1. The deduction is not allowed if the loss is "compensated for by insurance or otherwise" under 165(c)(3).
a. if the compensation is in a different year than the loss, and the loss has already been deducted, then the compensation is treated as ordinary income.
b. 164(h)(4)(E) denies a deduction for any personal casualty loss that may be covered by insurance if the taxpayer fails to file a timely claim with the insurance carrier to avoid higher premiums (which would be a nondeductible personal expense).

D. Floor for casualty loss deductions
1. Each individual loss is subject to a $100 floor- thus the first $100 of any loss is non-deductible.
2. Secondly, aggregate personal losses are allowable only to the extent that they exceed 10% of the taxpayer's AGI.

E. Casualty gains are treated as ordinary income. 165(h)(2)(b).

** Crane v. Commissioner, (1947)

2. Facts: Ms. Crane inherited a building (apartment house) for which the fair market value was equal to the amount of an outstanding mortgage of $262,000 (no equity). She rented it for several years, and took the depreciation deduction on the property each year for a total of $28,000 in depreciation. She then sold the property subject to the mortgage, and was paid $2,500 net of expenses. Thus, her total amount realized was $257,000 ($2,500 + outstanding balance on the mortgage). Ms. Crane asserts that her only gain was the $2,500, claiming that her basis in the property was zero, because when she inherited the property it had no equity. The commissioner argued that her basis included the amount of the debt owed on the property, and that basis had been reduced by the allowable depreciation deduction for each year, giving her a gain of $24,000 ($257,000-($262,000-$28,000)).

3. Statutes/Regulations: 1014

4. Issue: Is the amount of a debt used to finance a property included in the basis of the property even though the amount of the debt is greater than the amount of the equity?

5. Holding: Yes.

6. Reasoning: The court reasoned that the debt was includible in basis under 1014 because the amount of basis is cost (fair market value) regardless of whether the property was financed with debt or with equity. Since the taxpayer had used the fair market value of the property to determine the depreciation deductions, she had made a gain to the exent of those deductions. Also, the debt was included in the amount realized because since the debt was assumed, it amounted to debt relief. She had leveraged large depreciation deductions with debt, and so she should not be able to limit her gain to equity. Furthermore, it does not matter if the mortgagor is personally liable on the loan or not because as long as there is positive equity (the value of the property exceeds the amount owed on the debt) the mortgagor will treat the property as if he were personally liable because he stands to lose money in the amount of equity.

7. Notes: To allow the taxpayer to claim depreciation deductions on a non-recourse debt is to allow the taxpayer to recover the lender's capital in the property, while the lender still bears the risk of the decline in value of the property. The court in Crane left open the question of whether a mortgagor would realize a benefit if he were not personally liable on the mortgage and the property was worth less than the amount of the mortgage.

** Commissioner v. Tufts, (1983)

2. Facts: A general partnership purchased an apartment complex with a $1.8 million non-recourse loan. Over the course of the next two years, they contributed $44,000 in capital, and lawfully claimed $440,000 in depreciation deductions. The apartment complex had financial problems, and the partners each sold their interests subject to the mortgage to a third party. At the time of the transfer, the adjusted basis in the property was $1.45 million, but the fair market value was only $1.4 million. Thus, the partners claimed a loss of the $50,000 difference between basis and fair market value. However, the outstanding balance on the loan was still close to $1.8 million. The commissioner argued that the amount of the outstanding loan was debt relief and includable in amount realized, bringing their total gain (not loss) to about $400,000.

3. Statutes/Regulations: 1014

4. Issue: Whether non-recourse debt is included in amount realized as well as basis if the fair market value of the property is less than the amount of the debt, meaning that the mortgagor apparently gains no benefit from the debt relief because he is not personally liable on the loan to begin with.

5. Holding: Yes.

6. Reasoning: The court reasoned that the fact that the amount of the loan exceeds the fair market value of the property is irrelevant. When encumbered property is sold or otherwise disposed of, and the purchaser assumes the mortgage, the associated extinguishment of the mortgagor's obligation to repay is accounted for in the compuation of the amount realized. Unless the outstanding amount of the mortgage is deemed to be realized, the mortgagor effectively will have received untaxed income at the time the loan was extended and will have received an unwarranted increase in the basis of his property. To permit the taxpayer to limit his realization to the fair market value of the property would be to recognize a tax loss for which he has suffered no corresponding economic loss because he has invested no capital in the property, but still enjoys the benefit of full debt relief.

7. Notes: "Phantom gain" is created when depreciation deductions are claimed that reduce the amount of basis to less than the amount of the loan. Eventually, this phantom gain must be accounted for upon disposition of the property.

I. Tax Shelters -

A. Sec.465 The at-risk limitation prevents a situation where the taxpayer may deduct a loss in excess of his economic investment in certain types of activities.
1. The amount at-risk includes:
a. the amount of any cash contribution,
b. and the adjusted basis of any non-related property contributed, and c. any amount borrowed for which the taxpayer is personally liable for payment out of his personal assets.
2. The amount at-risk does not include:
a. any amount the loss of which is insured,
b. any amount borrowed from any person with an interest in the same activity.
1) this prevents two partners in a partnership from extending each other recourse loans for which each is personally liable as a way to get around the non-risk limitations.
3. Any loss in excess of amount at risk may not be deducted in subsequent tax years unless the taxpayer increases his at-risk amount.

B. Sec. 469 limits losses on passive activities to the amount of passive income.
1. A passive activity is one in which the taxpayer does not materially participate.

I. Like Kind Exchanges Sec. 1031

A. Section 1031 provides for the non-recognition of gain or loss where property held for productive use or investment is exchanged for property of a like kind which is held for productive use or investment.
1. The property must be solely for like property under section 1031(a).
2. Any excess cash ("boot") is currently taxable under 1031(b).
3. The basis of the new property in the owner's hands is the same as the basis of the property exchanged under 1031(d).
a. Ex: If A exchanges the Clearview Apartments, whose adjusted basis is $170,000 and whose fair market value is $200,000 ($30,000 of equity), for the Tower Apartments owned by B, with an adjusted basis of $135,000 and a fair market value of $180,000 ($45,000 of equity) plus $20,000 in cash (called "boot"), then A realizes a gain of $30,000 ($180,000+$20,000-$170,000) of which the $20,000 boot is currently taxable because part of A's investment in Clearview has been converted into cash. A's basis in the Tower Apts is now $170,000 (same as his basis in Clearview). Thus, A still has $10,000 of unrealized appreciation in the Tower Apts, which when added to the boot recognized in cash, equals the amount of equity originally in Clearview. The entire amount of B's gain ($45,000 equity in Tower) has been converted to equity in Clearview and so is not presently taxed.
4. Sec. 1031(c) prohibits recognition of loss even where boot is received.

B. Qualifying Property
1. Property of a like kind - three categories:
a. "excluded property";
1) Stock in trade and property held primarily for sale - ex. exchanges of stocks and bonds are always recognition events unless exchanged for common stock of the same corporation.
b. real property;
1) "the nature or character of the property" is required to be of like kind, by the "grade or quality" is not thus almost all real estate is like kind.
2) under 1031(h), real property in the U.S. is NOT like kind to real property in a foreign country.
3) Limited interests in real estate may or may not be of like kind. Ex: In Comm. v. P.G. Lake, Inc., an exchange of oil production payments, restricted to a specified dollar value of production, for real estate was held not to be a like kind exchange.
c. personal property (other than excluded property)
1) Regs 1.1031(a) et. seq. provide that depreciable tangible personal property will be treated as like kind if it is within the same General Asset Class.
2) Intangible personal property is judged according to the specific nature of the underlying rights. Thus, the goodwill and going concern value of two separate businesses can never be like kind.
2. Use of Property
a. The transferred property must have been held by the taxpayer for productive use in a trade or business for investment.
b. The property received must be for holding for productive use or investment.
c. Whether property "is to be held" for the requisite use is based on the taxpayer's intention at the time of the exchange.

C. Policy
1. The principle justification found in the cases is that the change in the form of the investment in the like-kind exchange is not sufficient to break the esential continuity of the investment.

D. The "Exchange" requirement- The new property must be acquired through exchange and not sale.
1. In borderline transactions, it is normally the taxpayer's intent to create a 1031 exchange that controls.
2. The transaction qualifies as an exchange even if the property received was never owned by the other party.
a. if X transfers property to Y, and Y pays Z to transfer Z's property directly to X, it is still a non-recognition event (as long as Z is not an agent of X) because neither of the two principles (X or Y) received property that was not like-kind and the spirit of the transaction was an exchange.

E. Deferred Exchanges
1. 1031(a)(3) requires that the property received by the taxpayer:
a. be identified within 45 days of the date on which the taxpayer makes the transfer of property, and
b. received by the taxpayer within the earlier of 180 days or the date the tax return is due.
2. This avoids the problems of a deferred exchange acquiring the current benefit of deferred taxes when no like kind property can be found and eventually the buyer pays cash, thus disqualifying the transaction as a like kind exchange.

II. Involuntary Conversions and Other Involuntary Transactions
A. Involuntary Conversions
1. Generally, 1033(a) provides for nonrecognition of gain where property is destroyed, stolen, seized, condemned, or sold under threat of imminent condemnation, and replaced with property "similar or related in service or use" to the former property.
a. The taxpayer normally uses insurance proceeds to purchase the replacement property, so any amount not reinvested becomes taxable.
b. The basis of the old property is transferred to the new property, together with any additional investment, and minus any gain realized.
c. 1033 applies to gain only; it does not restrict recognition of loss.
d. The taxpayer (or his representative) must himself make the replacement.
e. In lieu of purchasing related property, the taxpayer may acquire an 80% stock interest in a corporation that owns related property.
2. Definition of "involuntary conversion"
a. conversion other than condemnation must meet a high standard of "involuntariness."
b. actual condemnation must require the sale of the property to be involuntary.
c. the threat of condemnation is sufficient if the taxpayer has reasonable grounds to believe that the property will eventually be condemned.
3. Identifying proceeds from involuntary conversions
a. severance damages - where part of a property is taken in condemnation, there may be damages to the land not taken; amounts awarded for such damages are severance damages and are not part of the gain for 1033 purposes.
b. payment by the condemning authority for moving property not condemned are not part of gain for 1033 purposes.
4. Definition of "similar in service or use"
a. "functional use" test applies for trade or business property.
b. "nature or investment" test is applied where the taxpayer is an investor-lessor (similarity of risks, management burden, etc.) c. "like kind" test is used for condemnation of certain real estate. 1033(g)(1).
5. Replacement must take place within 2 years of the close of the taxable year in which any gain is realized, except in 1033(g) (like kind land replacement) which is 3 years.

B. Sale and Purchase of a Principle Residence Sec.121; 1034
1. 1034 provides for non-recognition of gain from the sale of a residence, provided a new residence is purchased within 2 years (either before or after sale of the first).
a. nonrecognition is allowed only to the extent that the purchase price for the new house equals or exceeds the sale price for the old house (otherwise the seller is pocketing the difference as profit and not reinvesting).
b. the basis of the new residence is reduced by the amount of gain that would have been made on the sale of the old residence, thus providing for deferral of the gain.
c. under 1034(d)(1), this rollover is allowed only once in any 24-month period unless the subsequent sale is caused by an empoyment-related move.
2. Sec. 121 provides that a taxpayer over 55 may exclude up to $125,000 (becoming exempt income) on the sale of a principle residence if during the 5-year period preceding the date of sale, the taxpayer has been living there as a principle residence for 3 years.

I. Capital Gains

A. "Capital Asset" requirement
1. Sec. 1222 defines "capital gain" and "capital loss" in terms of the "sale or exchange of a capital asset."
2. Sec. 1221 defines the therm "capital asset" as "property held by the taxpayer (whether or not connected with his trade or business)" and then lists five exceptions.

B. Capital Gains eligible for the preferential rate
1. 1(h) applies only to "net capital gain" as defined in Sec. 1222.
a. Long-term capital gains are on assets held over one year, and are taxed at the reduced rate.
b. Short-term capital gains are on assets held one year or less, and are taxed as ordinary income.
c. Net-capital gain is long-term capital gain minus short-term capital loss.

C. Capital Loss limitation
1. Short-term capital losses are subject to the same limitatoins as long-term capital losses.
a. both are carried over if the taxpayer has excess losses (exceeding capital gain income + $3,000/yr), but the short-term losses are used first under Sec. 1212.

D. Relationship to other provisions
1. A loss must qualify under Sec. 165 (or some other provision) as being allowable, before Sec.Sec. 1211 and 1212 are consulted to see if the loss is a capital loss.
a. ex: the loss on the sale of a personal residence is not deductible under Sec.165, even though 1211 would permit the offset of the loss against any other capital gains if it were deductible.
2. Sec. 469 limits any losses in passive activites, including capital losses.

E. Qualified Small Business Stock
1. Sec. 1202 provides that 50% of the gain from the sale of the stock of a small business is excludable (and the rest subject to capital-gains 28% rate) thus reducing the effective tax rate to 14% if:
a. the amount of the exclusion is less than either $10,000,000 or 10x the aggreagate basis in the stock (1202(b)(1)).
b. the aggregate gross assets of the corporation on or before the date of stock issue is $50,000,000; and
c. the corporation is engaged in "active business", excluding corporations that have 10% or more of their business in service, real estate, banking, or other passive businesses.

** Suburban Realty Co. v. United States, (1980)

2. Facts: Suburban acquired an interest in some 1,700 acres of real property in Texas in 1937. Over the next 31 years, they apparently sold portions of the property. Then between 1968 and 1971, apparently coinciding with the creation of a highway, they sold six different parcels of that real-estate. Suburban initially reported the income from these transactions as ordinary income, but later filed claims for a refund asserting that it was entitled to long-term capital gains treatment.

3. Statutes/Regulations: 1221(1) exclusion of ordinary business income from capital gains treatment.

4. Issue: When a real-estate company holds undeveloped land for several years, but then sells that land at a profit, is the real-estate company entitled to capital gains treatment of the profits from the land if: 1) they were at all times engaged in the business of selling real estate, 2) they were holding the real estate in question primarily for the purpose of sale, and 3) the sale of the real estate was "ordinary" in the business?

5. Holding: No.

6. Reasoning: The court saw these transactions as having an investment side as well as having an ordinary business side. Previous cases, including Biedenharn had provided "factors" for determining whether these close cases should be treated as capital gains or ordinary income. The most important factor was whether the sales were substantial and frequent, although that alone was not controlling. The court returned to the statute 1221 for guidance and formulated three questions that would be determinative of whether this was "property held by the taxpayer primarily for sale to customers in the ordinary course of business." First, they asked and concluded that Suburban was in the business of selling real estate. Second, they determined that Suburban's purpose for holding the real estate was primarily for sale in the real estate business, mostly because of the continuity of sales over the years. Thirdly, they quickly concluded that sale of real estate was ordinary in Suburban's business. They also considered that Congress' intent in ameliorating the hardship of taxing a long-accrued gain in a single year was not defeated by treating this transaction as ordinary income.

7. Notes:

A. General
1. The difference between "investment" and "business" property is normally a factual one.

B. Nature and Purpose of holding the property
1. Even if a person is not a dealer by primary trade, property can be termed "business" property if the frequency and continuity of sales is significant.
a. In Goodman, a lawyer specializing in real estate law was held to have ordinary income on the sale of 32 plots of land over 3 years because of his level of involvement in the transactions made real estate sales one of his businessexs.
2. The activities of a taxpayer's employer are not attributed to the taxpayer to demonstrate "business" characterization of property.
3. A dealer in property is not precluded from being able to hold property for investment rather than business purposes, but the taxpayer must show that it was not sold in the ordinary course of business.

C. "Liquidation" of an investment - change of purpose
1. Generally, if a person who has invested in a property later decides to sell it, there will be a question of ordinary income if the property has to be sold in several small chunks.
2. The subdivision, improvement and sale of land will normally generate ordinary income because the improvement activity will be viewed as being the primary purpose of the holding.
3. If there is no improvement to the property, or if it has been inherited, that may be enough to keep the investment nature intact.
a. In Estate of Simpson, the sale of 466 lots of a subdivision over 20 years was held to generate capital gain as liquidation of inheritance even though the inheritors opened a real estate office, became licensed, and hired employees.

I. Breakdown of Section 1221

A. Section 1221(1) requires that the property be held primarily for sales to "customers", thus a "trader" in securities on the stock market realizes capital gains for lack of a "customer", even though his sales are substantial and continuing.

B. Section 1221(2) - since businesses often buy equipment, use it, depreciate it, and then resell it before the end of its useful life, 1221(2) favors the sale of this equipment at a loss by excluding depreciable property from the definition of capital assets.

C. Section 1221(3) addresses the difference between personal services and "property" generated by personal effort (intellectual property). 1. Copyrights, literary works, and musical or artistic compositions, as well as software, are not capital assets to the creator, and their sale results in ordinary income to the creator, although sale by the subsequent purchaser is characterized according to the normal test of whether the property was held for sale to customers in the ordinary course of business. 2. Letters and memoranda are also excluded to prevent public figures from taking a deduction for the contribution of the letters to charity, because since they are not capital assets to the creator, the creator's basis is zero under the charitable contribution rules. 3. 1221(3) does not cover patents.

** Corn Products Refining Co. v. Commissioner, (1955)

2. Facts: Corn Products was a major manufacturer of corn products, and as such had a tremendous need for large volumes of low-priced corn. After the depression years, Corn Products began to purchase corn futures to obtain a stable-priced supply of raw corn without having to construct large storage facilities. In 1940 it netted a $680K profit in corn futures, and in 1942 it suffered a $110K loss. It originally reported these transactions as ordinary profit and loss from its manufacturing business, but later sought the preferential treatment of "capital assets", claiming that it was a "legitimate capitalist" speculating in corn futures, separate from its manufacturing business. Both the Tax Court and the Court of Appeal found the transactions to be ordinary hedging against corn price increases.

3. Statutes/Regulations: 1221

4. Issue: Whether gains and losses arising from the buying and selling of commodity futures by a manufacturer who uses the commodity as a raw material are capital gains and losses or ordinary gains and losses when there is substantial evidence that the futures trading was conducted to provide a stable supply of the commodity to the manufacturer.

5. Holding: No. They are ordinary income and losses.

6. Reasoning: The court reasoned that the purchase of corn futures was vitally important to the company's business as a form of insurance against increases in the raw price of corn. It also obviated the more expensive option of keeping large storage facilities. The company's own representatives testified that the activity was not for speculation but for hedging. Although 1221 did not explicitly exclude commodities futures from being capital assets, to hold otherwise would permit those engaged in hedging transactions to transform ordinary income into capital gains at will because they could either sell the futures and buy at the spot price (thus getting the capital gains treatment) or hold the futures for actual delivery if the spot price was unfavorable.

7. Notes: The Corn Products decision has been criticized as being too broad and subjecting the determination of capital assets to unpredictability where there is a mix of investment and business objectives. However, Corn Products is favorable to companies who have losses which appear to be capital in nature. The company will argue that they are ordinary losses in order to be able to offset the loss against ordinary income (to overcome the limitation of capital losses to capital gains).

** Arkansas Best Corp. v. Commissioner, (1988)

2. Facts: Best is a diversified holding company that purchased controlling shares in a bank in 1968. Over the next few years, Best increased its investment in the bank as the bank grew. Eventually, in 1972, the bank began to have problems because of its over-investment in real estate loans, and so Best invested some more money to cover those portfolio problems. In 1975, Best sold most of its interest in the bank, and reported the losses of $10 million as ordinary losses. The Tax Court found that the pre-problem investments were capital losses, but the post-problem expenses were ordinary losses. The Court of Appeal found that all investments were capital losses, and thus only deductible to the extent of capital gains.

3. Statutes/Regulations: 1221

4. Issue: Whether capital stock held by a holding company is a "capital asset" under 1221 regardless of whether the stock was purchased for a business or investment purpose.

5. Holding: Yes.

6. Reasoning: The court rejected Best's argument that "property held by the taxpayer (whether or not connected with his trade or business)" does not include property that is held for a business purpose under a "motive" test as being unsupportable in the language or intent of either the statute or the holding of Corn Products. The court stated that "capital assets" is a broad category, and the exceptions listed in the statute are exhaustive rather than illustrative. The court stated that the Corn Products case did not stand for the proposition that "capital asset" should be narrowly construed based on the primary purpose of the holder. It did not create a general rule that capital assets acquired for busines purposes could not be treated as generating capital gains or losses upon disposition. The court limited Corn Products to a specific application of the business inventory exception. Motivation for purchasing the property is irrelevant.

7. Notes: The lower courts have not applied Arkansas Best uniformly. Although it is clear that Arkansas Best held that the subjective intent of the taxpayer at the time of the purchase of the property is not controlling, many cases have held that the Corn Products analysis of the business use (as opposed to business purpose) is still valid. For example, Circle K v. U.S. read Arkansas Best narrowly to allow ordinary loss treatment of losses from the sale of corporate stock of a crude oil supply company that Circle K had invested in partly to ensure stable oil supply and partly to expand their business into the oil market. The court in Circle K held that the purchase of common stock of a company that is a "source of supply" is an inventory hedging practice and thus, ordinary. In FNMA, the court held that the buying of interest rates futures contracts was a surrogate for the mortgages that the FNMA held, and thus were hedges in the same way that the corn futures contracts were surrogates for the actual corn in Corn Products.

I. Quasi-Capital Assets

A. Section 1231(a) and (b) pick up the property excluded under 1221(2) and restore that property to capital asset status for gain purposes if held for more than one year.
1. Section 1231 applies to:
a. Sales or exchanges of "property used in the trade or business" which is either depreciable property or real property and which is held for more than one year.
b. Involuntary conversion of property used in a trade or business or capital assets held for more than one year in connection with a trade or business or a transaction entered into for profit.
2. The rule of 1231 is that:
a. If 1231 gains exceed 1231 losses, both the gains and losses are considered as arising on the sale or exchange of capital assets held for more than one year, ie., the net amount becomes a long-term capital gains that is used to determine net capital gains.
b. If 1231 losses equal or exceed 1231 gains, the losses are not considered as arising on the sale or exchange of capital assets, i.e., the net loss is an ordinary loss.
3. 1231(c) requires any 1231 net gain is taxed as ordinary income to the extent of the sum of any 1231 ordinary losses over the last five years. a. This prevents a taxpayer being able to avoid the netting requirement by claiming the gain and loss in separate years, and thus getting full preference for ordinary losses as well as full preference for capital gains.

B. Section 1245 provides that gains on dispositions of certain depreciable property are taxed as ordinary income to the extent of prior deductions for depreciation.
1. 1245 generally does not apply to real property.
a. As a result, owners of real property can realize an after tax profit on a transaction that merely breaks even by taking the full depreciation each year and offsetting against ordinary income, and then selling for capital gains treatment.
2. 1245 does not come into play if a 1231 asset is sold for a loss.
3. 1245 prevents conversion of ordinary income into capital gain where the depreciation deductions have been taken against ordinary income, and the taxpayer wishes to treat the resulting sale as capital gains
. a. Ex: Taxpayer purchases a machine for $1,000 and claims $400 in depreciation deductions. If the taxpayer then sells the machine for $1,100 (machine has appreciated), 1245 treats the first $400 of gain as ordinary income, and only the remaining $100 of gain as capital gain.
4. 1245 essentially limits depreciation to economic depreciation, even though the timing is still favorable.
5. 1245 prevents the taxpayer from taking interest-free loans from the gov't. in terms of accelerated depreciation, and then only paying back part of the principle because of capital gains treatment of the profit on sale.

I. Alimony

A. Payments qualifying as alimony
1. Sec.71(b) provides a uniform federal definition for alimony that does not depend on state law.
a. Sec.71(b)(1)(B) allows the divorced spouses to obtain the most beneficial tax treatment by allowing the parties to decide whether the alimonly will be deductible to the payor and includable in income to the payee, or neither.
2. Sec.71(f) eliminates disguising non-deductible property settlements as alimony by requiring that alimony payments for the first three years decrease by no more than $15,000 per year, otherwise the excess alimony is recaptured in the third year as included in the payor's income.
a. Ex: For alimony of $60K, $50K, $30K in years 1-3 respectively, the second year exceeds the 3rd by $5K over the limit. The $60K exceeds the average of the second year (adjusted down by the $5K) and third year by $7,500 ($60K-[{$45K+$30K}/2 + $15K]). Thus, in the third year, the payor is required to include $12,500 ($7,500+$5K) in income and the recipient is allowed to deduct that amount.
3. Sec.71(b)(1)(A) allows payments to a third party on behalf of a spouse to qualify as alimony, however Reg. 1.71-1T except the case where the payment is to a mortgage company or tax collector in order to maintain a house owned by the payor, even if occupied by the payee.
4. Sec.71(b)(2)(B) allows payments made under a written separation agreement to qualify as alimony.
5. Sec.71(b)(1)(C) requires that the payor and payee must not be members of the same household, thus overruling Syndes.

B. Child Support
1. 71(c)(2) reversed the Supreme Court rule in Lester, by treating as child support any payments that are reduced on the happening of a contingency relating to a child.
a. Payments that can be "clearly associated" with an event involving a child are viewed as child support.
b. Regs 1.71-1T state that a contingency is "clearly associated" with a child if it happens 6 months before or after the child reaches majority.
2. Sec.152(e) generally awards the dependency exemption for children of divorced parents to the parent having custody for the greater portion of the calendar year, regardless of the amount of support actually supplied by either parent, unless the custodial parent waives the exemption in writing.

C. Section 1041
1. Enacted in response to Davis, which held that a sproperty settlement between a husband and wife was taxable because the wife did not have co- ownership of the property.
2. Provides for non-recognition of gain in transfers of property between spouses, but requires the transferee to take at the transferor's basis. a. 1041(c) treats all transfers within 1 year of divorce as incident to the divorce and thus tax deferred.
b. Transfers outside the 1 year period are treated as "related" to the divorce if provided for in a written settlement document and occur within 6 years of the divorce.
c. Transfers prior to marriage are not covered.
3. 1041 does not apply to assignment of income earned by the transferring spouse prior to the transfer.
a. the transferor whose vested interest in earned income is trasnferred to a spouse must include payments to the transferee spouse in gross income, although an offsetting alimony deduction may be available.
b. 402(e)(1)(A) provides that the recipient of a pension plan from a settlement (QDRO) is taxed on the proceeds (transfer of an IRA account to a spouse during marriage or after divorce is a taxable event because it is an income stream, not "property.")
4. When a corporation that is closely held by the spouse is involved, care must be taken to see that the settlement is not viewed as a sale of property to the corporation instead of a non-recognition transfer between spouses.

** Lucas v. Earl, (1930)

2. Facts: The taxpayer entered into a binding contract with his wife in 1901 which stated that all property or rights to be earned by either of them in the future would be owned by them as joint tenants. The taxpayer filed tax returns in 1920 and 1921 that asserted that he was taxable on only half of his total salary and attorney's fees income because his wife immediately owned the other half as a joint tenant.

3. Procedural Posture: The Tax Court affirmed the Commissioner's determination that the taxpayer was taxable on the entire amount. The Court of Appeal reversed, and the Supreme Court granted cert.

4. Issue: Whether a taxpayer is taxable on the entirety of his income when the taxpayer signs a contract assigning half of his rights to all property to another.

5. Holding: Yes.

6. Reasoning: The court rejected the argument that [section 61] intended to tax only beneficially received income, that is income used for the benefit of the earner. The court stated that the statutory meaning was to tax all income from whatever source derived, and that it would be defeated if it could be so easily avoided as by providing for a contract vesting the income rights in another.

** Helvering v. Horst, (1940)

2. Facts: The taxpayer owned several negotiable bonds that had an interest stub (which represented the right to demand interest upon maturity) and a principle stub (which represented the right to demand the principle upon maturity). In the year of maturity, but before the bonds actually matured, the taxpayer gave the interest stubs to his son, who then cashed them in. The taxpayer claimed that he was not liable for tax on the interest because he did not receive it.

3. Statutes/Regs: 61(a)

4. Issue: Whether a taxpayer may be taxed presently upon making a gift of the interest stubs of a negotiable bond which are paid during the tax year of the gift.

5. Holding: Yes.

6. Reasoning: The court reasoned that the father had at one time legal title to the bonds. Although a realization event typically did not happen until the owner himself cashed them in, the realization may occur when the last step is taken by which the taxpayer obtains the economic gains which has already accrued to him. It did not matter that the father did not receive the interest directly, he controlled the disposition of the intersest stubs. Thus, he realized an economic benefit by transferring the stubs to his son. He gave the stubs in return for enjoyment of giving a gift. Even though he doesn't receive the money, he received the money's worth in satisfaction because they were presently negotiable bonds.

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