INTRODUCTION



Table of Contents TOC \o "1-3" \h \z \u INTRODUCTION PAGEREF _Toc292556188 \h 3COURSE INTRODUCTION PAGEREF _Toc292556189 \h 3CALCULATION OF TAX PAGEREF _Toc292556190 \h 4COMPLIANCE & ADMINISTRATION PAGEREF _Toc292556191 \h 6TIME VALUE OF MONEY PAGEREF _Toc292556192 \h 9TAX EXPENDITURES & TAX PENALTIES PAGEREF _Toc292556193 \h 11GROSS INCOME PAGEREF _Toc292556194 \h 13GROSS INCOME INCLUSTIONS PAGEREF _Toc292556195 \h 13GENERAL RULE: INCLUDE PAGEREF _Toc292556196 \h 13PROPERTY AS COMPENSATION PAGEREF _Toc292556197 \h 16LOANS AND CANCELLATION OF INDEBETEDNESS INCOME PAGEREF _Toc292556198 \h 19ILLEGAL INCOME PAGEREF _Toc292556199 \h 21EXCLUSIONS FROM GROSS INCOME PAGEREF _Toc292556200 \h 22NON Statutory EXCLUSIONS FROM GROSS INCOME PAGEREF _Toc292556201 \h 22IMPUTED INCOME PAGEREF _Toc292556202 \h 22REALIZATION PAGEREF _Toc292556203 \h 24STAUTORY EXCLUSIONS FROM GROSS INCOME PAGEREF _Toc292556204 \h 24CERTAIN CANCELLATION OF INDEBETEDNESS INCOME PAGEREF _Toc292556205 \h 24GIFTS PAGEREF _Toc292556206 \h 25QUALIFIED SCHOLARSHIPS PAGEREF _Toc292556207 \h 28DAMAGE AWARDS PAGEREF _Toc292556208 \h 28EMPLOYER-PROVIDED HEALTH INSIRANCE PAGEREF _Toc292556209 \h 28OTHER EXCLUDABLE FRINGE BENEFITS PAGEREF _Toc292556210 \h 29DEDUCTIONS PAGEREF _Toc292556211 \h 31PERSONAL DEDUCTIONS PAGEREF _Toc292556212 \h 31INTRODUCTION TO PERSONAL DEDUCTIONS PAGEREF _Toc292556213 \h 31CHARITABLE CONTRIBUTIONS PAGEREF _Toc292556214 \h 34CASULTY LOSSES PAGEREF _Toc292556215 \h 37NON-BUSINESS INTEREST EXPENSE PAGEREF _Toc292556216 \h 38MEDICAL EXPENSES PAGEREF _Toc292556217 \h 38MISCELLANEOUS ITEMIZED DEDUCTIONS PAGEREF _Toc292556218 \h 39BUSINESS EXPENSES PAGEREF _Toc292556219 \h 39ORDINARY AND NECESSARY, TRADE OR BUSINESS PAGEREF _Toc292556220 \h 39PUBLIC POLICY LIMITATIONS PAGEREF _Toc292556221 \h 41LIMITATIONS ON COMPENSATION PAGEREF _Toc292556222 \h 43BUSINESS VS. PERSONAL PAGEREF _Toc292556223 \h 45TRAVEL, MEALS, LODGING, ENTERTAINMENT, CLOTHING PAGEREF _Toc292556224 \h 45EDUCATION PAGEREF _Toc292556225 \h 47TIMING PAGEREF _Toc292556226 \h 49ANNUAL ACCOUNTING PAGEREF _Toc292556227 \h 49BACKGROUND: ANNUAL ACCOUNTING PAGEREF _Toc292556228 \h 49MISTAKEN DEDUCTIONS: § 111 and the Tax Benefit Rule PAGEREF _Toc292556229 \h 49MISTAKEN INCLUSIONS: § 1341 AND THE CLAIM OF RIGHT DOCTRINE PAGEREF _Toc292556230 \h 50TAX ACCOUNTING PAGEREF _Toc292556231 \h 51CASH METHOD PAGEREF _Toc292556232 \h 51ACCRUAL METHOD PAGEREF _Toc292556233 \h 53ECONOMIC ACCRUAL PAGEREF _Toc292556234 \h 54REVIEW AND PREVIEW OF TIMING ISSUES PAGEREF _Toc292556235 \h 56TAXATION AND THE FAMILY PAGEREF _Toc292556236 \h 56CHILDREN AND TAXATION PAGEREF _Toc292556237 \h 56MARRIAGE AND TAXATION PAGEREF _Toc292556238 \h 57THE EARNED INCOME TAX CREDIT & REPROSE OF TAX EXPENDITURES PAGEREF _Toc292556239 \h 60PROPERTY TRANSACTIONS PAGEREF _Toc292556240 \h 62TAX BASIS IN NONRECOGNITION TRANSACTIONS PAGEREF _Toc292556241 \h 62GIFTS, BEQUESTS, TRANSFERS BETWEEN SPOUSES PAGEREF _Toc292556242 \h 62LIKE KIND EXCHANGES PAGEREF _Toc292556243 \h 63CHARACTER PAGEREF _Toc292556244 \h 64THE MECHANICS OF CAPTIAL GAINS AND LOSSES PAGEREF _Toc292556245 \h 64WHAT IS A CAPITAL ASSET PAGEREF _Toc292556246 \h 64QUASI-CAPITAL ASSETS PAGEREF _Toc292556247 \h 66SOME PREFERENCES PAGEREF _Toc292556248 \h 66REPRISE: CHARITABLE DONATIONs OF APPRECIATED PROPERTY PAGEREF _Toc292556249 \h 66PERMANENT EXCLUSION OF GAIN ON THE SALE OF A PRINCIPAL RESIDENCE PAGEREF _Toc292556250 \h 67REPRISE: LIMITATIONS ON PERSONAL LOSSSES PAGEREF _Toc292556251 \h 67CAPITALIZATION & COST RECOVERY PAGEREF _Toc292556252 \h 68CAPITALIZATION & DEDUCTION PAGEREF _Toc292556253 \h 68RECAPTURE OF DEPRECIATION PAGEREF _Toc292556254 \h 72TRANSACTIONS WTH BOROWED FUNDS PAGEREF _Toc292556255 \h 72TAX SHELTERS AND LOSS LIMITATIONS PAGEREF _Toc292556256 \h 74INTRODUCTIONCOURSE INTRODUCTION Tax, defined The process by which a government transfers resources ($) from the private to the public sector Economists think the opposite is also true (tax expenditures)Code does not define taxDefinition of tax may depend on contextPurpose of tax – accomplishes a variety of objectives (not just as an income source)Revenue so government can do thingsInfluence behaviorDiscourageEg sin taxes on cigarettesEncourageSubsidies – corn tax creditEnact special policiesDistribute resourcesEg – taxing marriage, childbearing/rearingInformation gatheringEvaluating taxes (are they good?)Simplicity in understandingGovernmentTaxpayer (TP)Hard to avoidFairnessTreats likes alike AKA horizontal equityHorizontal equity – how to tell if they’re alikeIncomeFamily statusDisability statusIndustry – you can get a deduction depending on where you workCharitable contributions How you spend – savingsSource of income (wages, inherited income)Liquidity of $Eg if $ is trapped in your house it may not be a reason to tax it right nowTreat unalikes unalike AKA vertical equityAbility to pay principle (ATP) – the more you are able to pay, the more you do pay Progressive taxes – more you earn, more you pay as a % of your income VS flat tax – you pay same % of income regardless of income levelVS regressive tax – the more you make the less % you payEfficientFunctions as an incentive when we want it toRaise $ by not influencing behaviorRaises revenueExample$500 tax on BMW – how do we evaluateits simplefairnessaccords w/ vertical equity principle b/c high income paid does not accord w/ horizontal equity principle b/c it doesn’t equally tax all fancy carswont raise a lot of revenue b/c its easy to avoid (eg buy a Mercedes) but it will act as an incentive if that’s the goal – incentivizes not buying Mercedestypes of taxcapital gains taxbase – what you paid v. what you sold it for @ for a profit – timing is salesales tax head tax – each person pays same taxproperty tax – tax value of propertydeath tax/estate tax – timing is death, base is property in estategift taxincome taxindividuals (corporations) are taxedrates base is income – what income is is what this class is aboutCALCULATION OF TAX Code: §§ 1(a)-(d), f(1)-(2), (i), skim 1(h); 61; skim 62; 63; 31; 151Textbook: 21-23; 34-37Packet: 2014 IRS Form 1040; Rev. Proc. 2014-61, secs. pertaining to assigned Code sectionsProblem: 1Incomemany definitionsHaig-Simons definition of income (economist) (theoretical definition) – we can use it as our ideal definition of incomeConsumption + change in wealth (over a period eg a year)C + ΔWTax Credit – reduces your tax dollar for dollarDeduction – reduces incomeExclusions – reduce gross incomeFormula for calculating taxIncome – all income from whatever source derivedIncluding but not limited to …§61 definitionstarting position should be every source of income is included until we find an exemption/exclusion (in specific statutes, convention, judicial decision)eg – convention – proceeds from student loans§ 61 is said to get at entire constitutional right congress has to tax §61(a) General Definition – Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:(1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business;(3) Gains derived from dealings in property;(4) Interest;(5) Rents;(6) Royalties;(7) Dividends;(8) Alimony and separate maintenance payments;(9) Annuities;(10) Income from life insurance and endowment contracts;(11) Pensions;(12) Income from discharge of indebtedness;(13) Distributive share of partnership gross income;(14) Income in respect of a decedent; and(15) Income from an interest in an estate or trust.in generalabove the line deductions tend to be more business related in naturebelow the line deductions tend to be more personal in naturestandard deduction is inflation adjusted §63(c)(4)§14 Rev. Proc (p13 course pack)#s in §1 (tax) are inflation adjusted in the Rev. Proc. RatesYou’re taxed at a higher rate at your marginal $, the rate for your first $ is not raised no matter how much you makeMarginal tax rates matter for behavior – you know your after tax value of additional workDeductions are worth ($ value) x (taxpayer marginal rate)Matters for subsidiesMeans people in different brackets get different value for subsidiesExclusions are worth (amount of exclusion) x (taxpayers marginal rate)Subject to fewest # of limitations COMPLIANCE & ADMINISTRATIONCode: §§ 6662(a)-(c)Textbook: 30-33, 53-58, 65-69Packet: Understanding IRS Guidance; IRS definition of “voluntary compliance”Voluntary Compliancepaying your taxes isn’t voluntarywe mean, that it’s a system of self-reportingIRS definition – see “voluntary compliance” in GlossaryEmployer also reports your income to the governmentFICA (payroll tax on earned income) – funds social security and MedicareEmployer pays on your behalfIndividuals self report 1040 income yearly1099 reports other income (Eg contracting, interest, capital gain)someone else reports to you that they have reported to the government some form of your income (eg bank tells you that you earned $11 in interest + they’re telling the gov)government withholds income (est of taxes owed)set up to withhold too much, but you cant receive a return unless you file your taxes – it encourages us to do sowhy pay taxes (not actually voluntary) – Theories for Tax Compliancepenaltiesmonetarynon-monetaryprisoncollateral sanctionsinformation reporting/withholdingget public goodscollective actionsocial cooperationavoid auditsocial norm, civic duty, patriotism tax gapdifference between amount that was supposed to be paid and the amount that actually was paidsee table 5.1 (p55)types of guidancelegislative history + regulationstax questions in practice – code, regulations, case summaries, legislative history^ those authorities in that orderregulations prefaced by # and period (eg 1.xyz)capital “T” means temporary regulationrevenue rulings – how IRS would apply law to hypothetical factsbinding on IRS – taxpayer can rely on this revenue procedures – proceduralprivate letter ruling – before transaction, taxpayer asks IRS if he’s right – that taxpayer can rely on it, but others shouldn’t rely legally, but its made publicaka “comfort rulings”some issues IRS wont issue on (listed in revenue proc)ways to increase compliance B ≥ (B + P) x DB, tax benefitP, penaltyD, chance of detection + penalty (aka chance of audit)Left half of equation = expected benefit of lyingRight half of equation = expected cost of lyingExampleB ≥ (B + P) x D$100 ≥ ($100 + $20) x 0.01$100 ≥ $1.20therefore, penalty would have to be huge to ensure compliance by itselfpenalty would have to equal $9900 to make the “≥” change directions increasing “D” is very costly must disclose reportable transactions – § 1.6011-4 DNE listed transactions + similar transactionsconfidential transactionsminimum feecontractual protectionslarge losses ($50K)similar transactions ways to increase compliance we could put penalties on more peopleeg tax preparer and individual increase “D” by putting penalty on preparerwe could put on different kinds of penalties other than $ (eg accountants can get a professional ban)is there a way to require more information reporting? eg credit card receipts (in cash register at small businesses)BUT – people may offer discounts to deal in cash to avoid thisEg – information reporting on foreign transactions All foreign banks required to report directly to U.S. gov like domestic banks (now, post-Clinton deal) but government can only use it for enforcement of tax (confidentiality requirement)Universal reporting/publishing of tax forms BUT can incentivize in multiple directionsPROBLEM 1: Tax RatesLily, who is single and childless, will have taxable income of $100,000 this year. Consult I.R.C. §1 to calculate Lily’s tax liability for this year. Unless otherwise noted, assume that she has no available tax credits.(a) what is Lily’s total tax liability?Hint: I.R.C. §1 will refer you to inflation adjusted figures that can be found in a Revenue Procedure published annually by the government.$18,481.25 + 28% of the excess over $90,750.$18,481.25 + $2,950 = $21,071.25 (b) what is Lily’s average tax rate?The average tax rate is the total tax liability divided by taxable income. The average tax rate is a good measure of Lily’s overall tax burden and can be used to compare tax rates across taxpayers.$21,071.25/$100,000 = ~21%(c) What is Lily’s marginal tax rate?The marginal tax rate is the rate of tax Lily would pay on an additional dollar of taxable income – i.e., the extra tax that she would owe if her income were $100,001. The marginal tax rate will affect Lily’s tax decisions at the margin – i.e., how much an additional dollar of income or deduction will change her tax liability. 28%(d) suppose Lily were offered an opportunity to earn $1000 extra this year by doing some consulting work. In weighing whether or not to take the job, Lily might weight the value of her leisure time and the time needed for her other personal and professional commitments against the after-tax value of the consulting fee. What is the after-tax value of the consulting fee to Lily?$1000 – ((0.28)(1000)) = $720(e) assume that Lily decides not to undertake the consulting job, so her taxable income remains $100,000. Lily’s accountant calls and tells Lily that she’s going to be entitled to an extra deduction of $1,000. How much is the extra deduction worth to Lily?$280(f) What if Lily’s accountant tells her that she’s going to be entitled to a refundable tax credit of $1,000. How much is the tax credit worth to Lily?$1,000(g) Would your answers to (e) or (f) change if Lily’s taxable income were only $25,000?(e) - $1,000 – ((0.15)($1,000)) = $150 (f) - $1,000For Lily:$1,000 exclusion = $280$1,000 deduction = $280$1,000 credit = $1,000TIME VALUE OF MONEYTextbook: 19-20Problem: 1 (cont’d), 2Tax Planning is about 4 things(1) amount(2) source (U.S. or non-U.S.)(3) character (capital gains get a preferential rate)(4) timing – today’s topic (TVM)how often/when you pay taxTime Value of Moneya dollar today is worth more than a dollar tomorrowyou’d rather have a dollar today than a dollar tomorrowyou’d rather pay a dollar tomorrow than a dollar todayPresent Valueamount that a sum of money to be received in the future is worth todaydepends on interest rate amount of time and until you get the money Interest Rateaffected by – risk, length of termDeferralpay tax later, but it’s the same dollar amountdeferring liabilities (like tax bill) is gooddeferral decreases the effective tax rate (see problem CB p19-20 for an example)Payroll Taxes(not a main focus of our class but we’re touching it here)payroll taxes are taxes on wages2015 amount changes every year – set by social security administration SS EEMed. EEMax TaxER Match/self employed$1-$118,5006.2%1.45%SSI: 7,345Med: 1,718In full/pay doubleIn full/pay double $118,501-$200,00001.45%SSI: 0Med: 1,181Match/doubleOver $200,00001.45% to 0.9%No limitNo match social security tax is regressive – you stop paying once you exceed a certain income (in 2015 - $118,501)Medicare tax is proportional until $200,000, then it becomes progressive if you include employer matching as employee borne, 75% of families pay more in payroll tax than in income taxAnnual Compounding Rate: Formula FV = PV (1 + r)nPV = FV/(1 + r)nFV = amount you’ll receive in the futuren = how long it will be before you receive it (# of periods)r = interest rate includes compounding period EXAMPLEEXAMPLE PVPV = FV/(1 + r)nPV = 1/(1 + .10)50PV = 1/11739PV = 0.0085EXAMPLE FVFV = PV (1 + r)nFV = 1(1 + 0.10)50FV = 117YearPrincipal @ beginningInterestPrincipal @ end010001001100111001101210212101211331313311331464Problem CB p19-20 13716003048000 2005-2010 is a deferral b/c gain comes in 2005 but tax isn’t paid until point of sale in 2010assume tax is 15% so its $750 in tax liability due in 2010so how much must they save in 2005 to make sure they have $750 in 2010? (interest rate 4%)PV = 750/(1 + 0.04)5PV = $617Deferral lowers effective tax rate:750/5000 = 15%617/5000 = 12.34%PROBLEM 2: The Time Value of MoneyYou may wish to use the table on p. 20 of the textbook to answer this question. Assume a 10% discount rate.(a) Would you rather receive(i) $3 in year 1, $2 in year 3, and $1 in year 5, or(ii) $2 in years 1, 2, and 3?PV = FV/(1 + r)n(i) – PV Year 1 ($2.73) + PV Year 3 (PV = FV/(1+ r)n = 2/(1 + .10)3 = 21.50) + PV Year 5 (0.62) = $4.85(ii) – [PV Year 1 (2(.909)) = 1.81] + [PV Year 2 (2(.826)) = 1.66] + PV Year 3 (2(.751)) = 1.50] = $4.89you’d rather receive option (ii)(b) Why would a taxpayer prefer to recognize income in Year 2 than in Year 1?It lowers the effective tax rate(c) Why would a taxpayer prefer to deduct the total cost of a three-year insurance policy when it is purchased in Year 1, rather than one third of the cost per year over three years?Accelerate anything that lowers your liability TAX EXPENDITURES & TAX PENALTIESTextbook: 24-26Packet: excerpts from Surrey & McDaniel, Tax Expenditures; Mason, Federalism and the Taxing PowerHaig-SimonsI = C + ΔW“Normal” baseline is U.S. Federal CodeTax Expenditurestax expenditure – when government spends $ through the tax codeways gov spends $ through the tax codedeductionscredits exclusionsdeferral of liabilityaccelerations of deductionsspecial rateExamplestaxpayersmortgage interest deduction = tax expenditurecredit for 1st x homeowner = tax expenditure 3rd partysubsidyguarantee loangov can lend below market ratetax expenditure – a deviation from the “normal” tax“normal” baseline is U.S. federal codespending through the tax code (through tax expenditures) is like direct spendingto be transparent we should consider tax expenditures as government spending see handout (1-30-15) “Analytical Perspectives” Table 16-3 (Tax Expenditures) just b/c something lowers your tax, doesn’t make it a tax expendituredeductions to accurately estimate your income do not count as a tax expenditureeg – cost of earning income is not a tax expenditure (b/c you need to spend $ to make $)indicator of tax expenditures (general rules – sometimes they don’t apply)attempts to induce behaviortargets a specific groupapply for expenditures (you don’t generally have to apply for regular deductions)social program/pursuing public policy goalexemption of economic incomedefinitional problemtax expenditures are deviations from the “normal” tax. But what is the “normal” tax?Tax expenditure budge goalInformationAccountabilityTransparencyCostScope/coverageOnly those w/ positive tax liability (i.e. must have income)Different politicsVotersCongressLegislative processTax committee controls tax expenditures instead of committees dedicated to particular subject matterTax expenditures do not go through appropriations – direct expenditures must get re-approved annually, while tax expenditures stay in the tax code until they’re removed Increasing tax breaks is a kind of government spending the political arena should regulate this!Criticisms/Jeers by authors of article (they disagree w/ these)Not really spending (not gov. funds)More individual control (private behavior)Tax Expenditures are simplerAdministrative apparatus Tax Expenditures are no worse than other forms of government spending (these features of tax expenditures can also apply to other forms of government spending)open endedwastefuldistort choiceallows taxpayers to decide eligibility Surrey’s article/idea has had great intellectual success but has made little practical/actual impactReasons to think Tax Expenditures ARE worseNo information (prior to article)No accountabilityMore hidden (not listed in budget)ScopeUpside down effectLargest benefits go to taxpayers w/ highest ability to pay b/c vast majority are exemptions that are worth more if you’re in a higher marginal tax rate bracketTax sheltersMake expenditures more expensive than government accounted forTax expenditures keyed into tax rates so incentives fluctuate w/ tax ratesAdministrative confusionOver who’s supposed to administer Eg remember IRS tea party scandalConstitutional differences between tax credits and direct expendituresFor establishment clause (at least)Eg taxpayer standing to challenge tax credits to religious schoolsEg Arizona… v. WinnCourt makes all the arguments Surrey (author article) jeers atCongress can do through a tax penalty that which they cannot do through direct regulation (Eg healthcare mandate)Tax PenaltyIf you pay more taxes than you would have to under a “normal” taxCongress deliberately over-taxes something to achieve some goal (eg high cigarette tax)GROSS INCOMEGROSS INCOME INCLUSTIONS GENERAL RULE: INCLUDECode: §§ 61; 1001(a)-(c); 1012(a)Regs: §§ 1.61-1(a); 1.61-2(a)(1), (d)(1); 1.61-14(a); 1.61-21(b)(1)-(2)Textbook: 71-79 (through Example 1), 111-114Packet: Old Colony TrustProblem: 3What is Incomewe tax on net income (not gross income) – we let you deduct the expenses of your incomewe do this to preserve horizontal equity + tax on ability to paywe don’t distinguish how long it takes you to make your income though (someone who works one hour and earns 1K gets taxed the same as someone who works 10 hours and earns 1K total.Income defined §61Gross income – all income from whatever source derived unless there’s an exception provided in the codeIf income is goods, you use the fair market value Rooney v. Commissioner (p111)Facts – restaurant /pharmacy owed a debt to an accounting firm. The accounting firm takes goods/services to lower their debts. Accounting firm argues that (eg) a $90 bill at the restaurant is not worth $90 (objective value), it is worth some lower subjective amount because they’d rather their debts be paid in cash We assume exchanges take place at FMV (for convenience)Holding – accountants must use the objective FMV (not their subjective value) because we can’t have an administrable tax code where each customer values his own goods/services/exchangesObjective value = fair market value “FMV” – the amount owed for the same goods/services by neutral third partiesValuation is a general problem in the tax codeFair Market Value (FMV) – the price at which 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 (p112) (Estate Tax Regs)Reg § 1.61-1(a)Form of payment doesn’t matter Commissioner v. Glenshaw Glass Co. (p71)Facts – (2 consolidated cases) parties received compensatory damages & punitive damages. Taxpayers argued that compensatory damages are income, but punitive damages are notIssue – are punitive damages income that is taxable?Taxpayers argue based on a “windfall” argument from Eisner v. Macomber (widely criticized opinion saying income derives from capital, or labor, or capital and labor) saying that the “windfall” was not the result of the capital invested or labor, it was just to punish the sued party Court interprets §22(a) (now §61) – definition of gross incomeHolding – interpreting §22, punitive damages must be included in incomeLesson – source does not matter; income “from whatever source derived”Famous description when someone has income = “undeniable accession to wealth, clearly realized, over which the taxpayers have complete dominion” (p73)Realization requirement (“clearly realized”)“when” matters b/c TVMrealization governs “when”trade = trade for something materially differentrealization can get you a deferral (?) of gains & lossesdeferring gains lowers effective tax ratedeferring losses raises effective tax ratewe have a realization requirement because:it helps find ability to pay in liquid assets; easier to determine FMV; limits problems with volatility (stocks going up and down); administrative simplicity; incentivizes savings problems with realization requirement:gov misses revenue; horizontal equity problem; stagnation – people lock in assets because they don’t want to pay + sell taxes; inefficient for some reasonhow to calculate gain§1001gain – excess of amount realized over the adjusted basis loss – excess of adjusted basis over amount realizedbasis – after tax investment in the value of the asset (usually what you pay for the asset unless you sink money into it)realization eventssales, any exchange, trade asset for cash or another asset, windfalls, trading something for nothing Cesarini v. U.S. (p75)Reg § 1.61-14 – treasure troves are (taxable) incomeReason for taxing treasure troves – won’t distort behavior b/c you got it for nothingFacts – family buys old piano in 1957. In 1964 they find $4,467 inside. They report it on their tax return, then they file an amended return saying that $ is not taxable for 3 reasons (1) not income, (2) if income, it was taxable when they bought it and the statute of limitations (SoL) has run, (3) treasure trove4114800217170StackingTotal Tax Due – Tax that would be due on non-salary income = what Wollen (company) paysEmployee pays lowest stack0StackingTotal Tax Due – Tax that would be due on non-salary income = what Wollen (company) paysEmployee pays lowest stackHolding – (1) it is income – source doesn’t matter; you don’t have to earn it; (2) income realized when they discovered $, not when they bought the piano. PROBLEM 3For each of the following consider whether Amy must report each discovery as gross income:(a) Amy finds a $100 bill floating in the oceanYes, income upon discovery(b) Amy finds a gold coin sitting at the bottom of the oceanYes, income upon discovery(c) Amy finds a diamond necklace worth $15,000 inside a piano she recently purchasedYes, income of $15,000 (FMV) upon discovery(d) Amy discovers that the piano she recently purchased is a Steinway worth $15,00, far more than the $2,000 she paid for it. Both she and the seller regarded the $2,000 price as fair.Yes, its income taxable when she sells it (e) Amy discovers oil on her property worth $50 million.Yes, income taxable as oil is severed from the land (not at discovery)(f) Three years later, Amy sells the diamond necklace that she found inside the piano for $18,000. How much income does she have due to this sale?G(L) = AR – ABG(L) = 18,000 – 15,000G = 3,000Old Colony Trust v. IRS (supplement) (1929)Facts – the company (Wollen) agreed to pay the income tax of select employeesIssue – is the payment of the tax additional income? If Woods WinsIf Woods looses & pays taxOther taxpayers (but co. does not pay tax)Total Comp1,000,000700,0001,700,0001,700,000 (salary)Tax700,000700,000 (what employer paid)+ 490,000 (what estate ends up paying)1,190,000700,000 (tax on 1M)+ 490,000 (tax on 7K)1.19MAfter Tax Income1,000,000510,000510,000ETR (effective tax rate)41%70%70%holding – extra $700,000 (tax paid by company) constitutes income to employeeanything your employer gives to you constitutes income unless there’s an exceptionreasoning – similar taxpayers should be treated similarly (see final row of chart)for Woods (employee) to get 1M after tax:GI = ATI/(1 – t)GI = 1,000,000/(1 – 0.7)GI = 3,300,000Called “gross-up”to calculate after tax income (ATI)ATI = GI x (1 – t)GI = ATI/(1 – t)GI = gross incomet = tax rate (average tax rate)Note – form of income does not matter (cash, payment of debts)Tax on Tax issue – If the gov taxes 1.7M, the tax on the 0.7M is a tax on a tax. If the company pays that tax, then it is also income and that payment must be taxed. It is an infinite loop. The S.C. doesn’t answer this problem in Old Colony, but the way to answer this problem is to gross up. PROPERTY AS COMPENSATION Code: §§ 83(a), (b), (c), (e)(3), (h)Regs: §§ 1.83-1(a)(1), (b)(2); 1.83-2(a); 1.83-3(e)Textbook: 221-229Problem: 4whenever you’re compensated for services, your income is ordinary incomepayment by property is also taxable income§ 83 – property as compensationtransfers of property for servicestiming amountwho reports (always service provider)character (ordinary income – OI)if someone performs a service and is paid in property, that property is income right thenif strings are attached to that property, then it is taxable when the income is realizedreasons for paying in property – stock is the most familiar exampleretention5yr vesting periodperformancecash strappeddefinitions – Reg §1.83-3 – substantial risk of forfeiture - §1.83-3(c)(2) – vesting period > 2 yr property – real + personal property; anything other than an unsecured promise to paytransferred – if the service provider has a beneficial interest in the propertysubstantial risk of forfeiture - §83(c) – if rights to full enjoyment of property are conditioned upon the future performance of substantial services or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.if it’s a deal that no one else can get, that will indicate that the transfer was made for the performance of services – Alves v. Commissioner (p224)exclusivitynot a requirement that the service recipient gets a bargain in the deal. §83 still governs even if you pay FMV.§83 tells you whenproperty is taken into income when it fully vests (not subject to the substantial risk of forfeiture) function of §83 is to defer incomereasons for §83deals with liquidity problemequity problem – you don’t really own it – its not fair to tax on itvaluation problem when its subject to restrictionsBASIS – after tax investment; what she paid + what she was taxed onEXAMPLEEXAMPLE – Simple, non §83 problem50 shares unrestricted stock = $1500she pays = $500 _______Income =$1,000- §61Here, basis = $1500 b/c $500 she pays + $1000 income EXAMPLE – PROBLEM 4Jess, an employee of Wyndham Production Inc., receives 50 shares of Wyndham Production stock as a year-end bonus. In Year 1, the time of receipt, the stock is worth $1500. Pursuant to the terms set by Wyndham Production, Inc., the stock cannot be sold or otherwise transferred for at least five years after receipt, and if Jess stops working for the company during this five-year period, she must return the stock to the corporation. In Year 5, after the stock vests, she sells the stock to Mark for $2500. (a) What are the tax consequences to Jess in Year 1? In Year 5?Stock has a substantial risk of forfeiture, so you get a deferral unless you elect to pay now under §83(b). But the default is deferral under §83(a).Year 1 – no consequencesYear 5 – sale – capital gain = 0 83(a)83(b) electionGrant Y1FMV = 1500deferral OI = FMV – amount paidOI = 1500 – 0 = 1500Basis = 1500Vest Y5FMV = 2500OI = FMV – amount paidOI = 2500 – 0 B = 2500n/a – deferral Sale Y3FMV = 2500G(L) = AR – AB where B = FMV @ vestingG(L) = 2500 -2500 = 0 Capital Gain = 0 G(L) = AR – AB where B = FMV @ vestingG(L) = 2500 – 1500Capital Gain = 1000 (b) Do your answers change if Jess makes an election under Section 83(b) in Year 1?See column 4 ^(c) What happens if Jess makes the 83(b) election in Year 1, but the stock losses value, so that in Year 5, she can only sell it to Mark for $1000?Grant Yr 1 = FMV – amount paid = 1500 – 0 = 1500 (taxed on it)Sale Yr 5 = CG(L) = AR – AB = 1000 – 1500 = (500) (taxed on it?)(d) What happens if Jess makes the Section 83(b) election in Year 1 and then, in Year 3, she stops working for Wyndham Production and returns the stock to the company?She forfeits the stock but has already paid tax in year 1 with a $1500 basis. You don’t get a deduction for that loss (see §83(b))(e) What are the tax consequences to Wyndham Production of each of the above situations? Employer’s deductions follow the employees inclusionsAt time of vesting if no election is madeAt time of grant if election is made Choosing between §83(a) and §83(b) is choosing if you want to be taxed at time of grant (§83(b)) or at the time of vesting (§83(a))Gamble – if you make the election (to be taxed at the time of the grant), you think that the asset will appreciate such that you come out aheadIf you pay FMV you should always make the §83(b) election (b/c the tax will be $0 – Alvez)§83 only applies to service providersways §83 election can go wrongvalue of stock could go downrisk w/ TVOM (time value of money)you could invest $ and gain now by paying laterforfeiture if you leave the companytax rate could lowerholding rate/periodif you hold property ≥ 1 year, you get a good capital gains tax rateholding period advantage if you make a §83(b) election because the holding period begins when substantial risk of forfeiture ends§83(a)§83(b)GrantN/AOI = FMV – Amt. PaidVestOI = FMV – Amt. PaidN/ASale, if anyGG(L) = AR – ABWhere B = FMV @ vestingCG(L) = AR – ABWhere B = FMV @ grantabbreviationsAB = adjusted basisAR = amount realizedOI = ordinary incomeB = basisCG(L) = capital gains (or loss)LOANS AND CANCELLATION OF INDEBETEDNESS INCOMECode: §§ 61(a)(12); 108(a), (d)(1)-(3), (e)(1)-(2), (5), 165(a), (c)(2); 166Textbook: 143-146 (stop after Note 6)Problem: 5General Treatment of Debt:Lending PrincipleRepaying PrincipleInterestCancellation of Debt (COB)BorrowerNo inclusionNo deductionCandidate for deductionPersonal debt = non-deductBusiness debt = deductibleInclusion of balance of principle upon discharge of debtLenderNo deductionNo inclusionIncludableDeduction §166If the transaction is a loan for the borrower, it should also be a loan for the lenderDebt has two minimum requirements(1) transfer of principle must be consensual(2) must be an obligation to repay PROBLEM 5: Borrowing(a) Rob borrows $1,000 from the bank and spends it. Is the money he borrows income? When Rob repays the loan, can he deduct the $1,000 he repays? (Ignore, for now, the question of whether the interest Rob pays on the loan is deductible.)no and no(b) Corporation X is issued 1,000 bonds with a face amount of $1,000 each. Corporation X received $1,000 for each bond issued (total $1 million). The bonds are now trading for $300 in the market because many investors think that the corporation will not pay off the bonds. Corporation X buys back all its bonds in the market and pays $300 cash for each bond (total $300,000). The fair market value of the corporation’s assets exceeds its total liabilities both before and after the bond buyback. Does Corporation X have any income for tax purposes as a result of the transaction?Yes – answer hinges on solvency which is why we’re told assets exceed liabilities (we know §108 doesn’t apply) (c) Would your answer change if Corporation X’s buyback of its bonds were pursuant to a bankruptcy plan approved by a Federal court in a Chapter 11 bankruptcy proceeding? Are there any collateral tax consequences to Corporation X in that case?Tax consequences for buying back debt are no inclusion (§108(a)(1)(A))Collateral consequences – yes; you have to reduce any net operating loss you have, or general business credit, etc. (see §108(b)(1)) sort of a deduction, not an exclusion under §108(b).(d) Sue sold an apartment building to Taylor in exchange for Taylor’s $2 million promissory note, which bears interest at a market rate. Taylor later discovers that the property is contaminated with asbestos, and, as a result, he must incur $500,000 of asbestos removal costs. The contract of sale had warranted the building to be free of asbestos. Sue agrees to reduce the amount of Taylor’s debt by $500,000 to avoid a lawsuit. Does Taylor have income for tax purposes as a result of the cancellation of part of his debt?No (provided he’s not insolvent or bankrupt, etc.) pursuant to §108(e)(5) – it’s a purchase price adjustment, not income. United States v. Kirby Lumber Co. (1931)(p143)issues debt – borrowerFacts – issues 12M in debt; Kirby did not include as income; They Kirby buys some debt back at a discount of 140KIssue – is this income?Holding – yes. Enriched by 140KILLEGAL INCOMETextbook: 148-157Collins v. Commissioner (1993) (p148)Facts – Collins steals 80K (betting tickets). Collins wins 42K which he pays backIssue – is the difference (80K – 42K) income?Holding – yes (mostly for public policy reasons)Collins’s arg – #1 – He’s in debt; he has an overall loss, so it’s not incomeResponse – you must think of the income separately from what was done with it; separate the theft from the betsCourt says – Collins stole 80K & he got the benefit of 80K#2 – I don’t have income because I must repayCourt responds – this is not a consensual transfer so it can’t be a legitimate debt#3 – double punishment – I’ve already been punished by the criminal lawcourt responds – criminals income should be taxable, we shouldn’t treat ill gotten gains better than legitimate activity; taxation isn’t punishment #4 – valuation – not really 80Kresponse – we use FMV of tickets to value things for tax purposesCourts allow a deduction for the 42K restitution (there’s no statutory authority for this but the Court allows it by analogy)Rule for gambling – you can only deduct your losses limited to your gambling gainsRule – illegal gains are taxable income Court distinguishes Zarin Taxes on illegal activityStates may tax some things more to discourage them (tax penalties)Stamp taxes for drugs – heighten penalty for drug trafficking Cancellation of Debt “COD” is generally income§108 is an exception to §61§108 is an exception to the rule that COD is income(B) the discharge occurs when the taxpayer is insolvent(A) Title 11 bankruptcyentire list in §108 is exhaustivejustificationswe want lenders to be repaid before gov. taxeswe want those who are bankrupt/insolvent to have a chance to make $ in the futurecollateral tax consequences in §108(b) – which generally have you reduce other losses by the amount of reduction under §108(a)(1)§108(e)(5) – cases where the debt is between the buyer & seller of property – someone selling you something finances that purchase§108(e)(5) if the seller, who lends to you for your purchase, reduces the amount you owe, its treated as a purchase price adjustment (which isn’t income) if a 3rd party pays your debtthat is income (Old Colony Trust), unless there is an exception (Eg. cancellation of student loan debt §108(f))EXCLUSIONS FROM GROSS INCOMENON Statutory EXCLUSIONS FROM GROSS INCOMEIMPUTED INCOMECode: §61(a)Regs: 1.61-1(a); 1.61-2(d)(1), (i)Textbook: 116-122Problem: 6Imputed Incomenon-cash benefits you do for yourselfthe value of goods/services you send to yourselfnot income for tax purposesBartertrading servicestaxable on the FMVis gross incomeCB Problem #6 p119practically, they’re not going to reportimputed income includes services you provide for families, close friendsthe question is where to draw the line between favors & bartered for exchangeshere, seems like favors that are not taxable as incomeCB Problem #7 p119seems closer to an actual bartered for exchange w/ an easily ascertainable (and high) FMVexpectation of reciprocity there’s an argument both ways but it looks more like a bartered for exchange but no one in this situation probably actually reports Miscfailure to tax imputed income, results in similarly situated taxpayers being treated differentlyeg – housekeeping spouse not taxedrationales for not taxing imputed incomeno real way to track – hard to verify (no 3rd party reporting)it will basically be a wash in the end if we tax everyone for brushing teeth, etc., in the end people will basically end up the sameinjects progressivity into the tax system (poorer people will provide more imputed services that will go un-taxed)politically unpopularit would be complicated – we’d have to allow more deductions, etc. imputed income is not always permanently un-taxableeg – increase in value at sale is taxed, if you purchase an item and up the value by putting in your own labor (labor hours aren’t taxed, but increase in value from that sale is taxed)Couple A – single earner, one spouse keeps houseCouple B – two earners, hire a house keeperTAXSpouse 1 earns100,000100,000Spouse 2 earns030,000Combined Taxable Income100,000130,000Tax @ 30%30,00039,000CASHEarnings100,000130,000Tax(30,000)(39,000)Payment to Housekeeper0(30,000)Bottom line70,00061,000homeownership is the largest amount of imputed income from propertyhousekeeping is the largest amount of imputed income from servicesnon-taxation of imputed income modifies behavior – it would be unwise for Couple B to have the second spouse enter the marketplace2 ways to fix this disparity (none of which we pursue)include imputed income as taxable in Couple Aallow a housekeeping deduction for Couple BHome owner – house investmentRenter – stock investmentInvestment50,000 (house)50,000 (stock)Imputed income5,000 (rental value of house)0Taxable income05,000 (stock returns)Tax @ 25%01,2505,0003,750these investments (property ownership v. stock) are taxed differently – will influence behavior (makes it more worthwhile to invest in property than in stocks in this example)REALIZATIONCode: §§ 1001(a); 1014Textbook: 122-124; 249-256Realizationfor the most part we defer taxation until dispositionEisner v. Macomber (1920)(p249)Facts – D has stock in standard oil. Standard oil has made a stock split (dividend)Eg – if D had 200 shares, standard oil made Ds share into 300 (2 for 3 split)200 stocks worth $100100300 stocks worth $100FMV = Income = $33 (100 shares)History – Pre 16th amendment – Constitution said taxes must be apportioned by population of states (eg head taxes)Income taxes are not proportional to population of states16th amendment authorized Congress to enact an income tax (tat is not proportional to the population)Issue – Congress enacted a law (Revenue Act of 1916) that made stock dividends taxable incomeIssue – does the Revenue Act of 1916 (which makes stock dividends taxable) violate the 16th amendment (16th amendment allowed Congress to enact the income tax)?Does Congress have the power to tax stock dividends?So now the issue is – are stock dividends income within the meaning of the 16th amendment? (and therefore can they tax w/o apportionment)? Reasoningcourt considers the dictionary definition of income (p250)distinction between capital + incomecriticism of this case b/c – everyone agrees Congress has the power to tax the increase in shares – Congress can mark to market (MTM)Holding – no income here that can be taxedStands for the principle that we don’t tax until realizationNote – if a company distributes the stock of another company, that is taxable STAUTORY EXCLUSIONS FROM GROSS INCOMECERTAIN CANCELLATION OF INDEBETEDNESS INCOMECode §§ 61(a)(12); 108(a), (f)(1)-(3)Textbook: 146-148, 719-722Packet: Rev. Rul. 2008-34, Zarin (time allowing)GIFTSCode: §§ 102; 274(b), 74Textbook: 81-93Problem: 7DonorDoneeTaxRateOption ANo deductionIncludeTwiceBothHaig-SimonsOption BNo deductionExcludeOnceDonor’s rate§102(a)Option CDeductIncludeOnceDonee’s rateIncome-shiftingOption DDeductExcludeNonen/aintent of transferor is what determines a gift (recipient’s intent does not matter at all)Gifts3 possible logical (4 total approaches to taxing gifts (see table above ^)Option A Haig-SimonsOne reason this is a problemIncome shiftingNot really an issue for Option A because its taxed at both rates, but in Option C it’s an issueUsually gifts are given from a high income bracket to a low income bracket, and we’re worried about people giving gifts to lower their tax rateOption BCurrent law in § 102(a)Usually ends up getting taxed at higher rate (b/c gifts given from rich to poor)Easier logistically to keep trackStatutory exclusion from income Option COne problem, its harder to know a donee gets a gift, than a donor has income (esp because the typical gift is in between families& we don’t want logistically to get into every little thing families give one another another problem – see income shifting in Option ACommissioner v. Duberstein (1960) (p81)facts –(A) – Berman sold products to Duberstein (metals) & sometimes Duberstein told Berman other customers info. Berman gave Duberstein a Cadillac as a thank you(B) – Stanton worked for Trinity church. When he resigned, Trinity said they’d give him $20,000 instead of pension. Issue – is this taxable income?Indicia of GiftIndicia of not gift(A) – friends (A) – payback(A) – 7 years(A) recompense for customer tips(A) – wasn’t expecting anything in return(A) – Mohawk (Berman’s Co.) deducts expense for carNOTE – matters b/c how donor treats transfer is indicia of intent if it’s a gift(A) – no obligation(B) – seemed like a severance package (b/c a guy who got fired got severance, & Stanton didn’t wait to get fired but resigned instead)(A) – “present”(B) Compensation for past services (B) – they said they really liked him(B) – label it a gratuity (B) – no obligation for church to make the payment(B) – compensation for past servicesIRS petitions for cert b/c they want a test – a bright line ruleThey want this test/rules:Corporations can’t make giftsIf giver deducted it’s not a giftGifts must be personal not businessFAILS – court declines to define gift Holding – standard for what’s a giftTransferors intent determines giftWas the transfer made with disinterested and detached generosity?Frankfurter Dissent (p87)Would provide a clearer ruleWould have a presumption for gifts in the family contextWould have a presumption against gifts in the business contextWhipsaw – when 2 parties take inconsistent tax positions; each favorable to him, but results in no one being taxedConcern – Duberstein excludesMohawk (Berman) deducts In gifts we’re concerned aboutincome shifting whipsawno gifts in employer/employee context (§102(c))no deductions for expenses for gifts (§274(b))(no deductions for donor)§102 takes care of both concerns ^RecipientTransferorCompensation (not gift)Include, §61Deduct, §162GiftExclude, §102(a)No deductionBusiness gift to employeeInclude, §102(c)Deduct §162Business “gift” to non-employeeTransferor deducts $0Exclude, if Duberstein giftn/aTransferor deducts $25Exclude, if Duberstein giftDeduct $25, §162, 274(b)Transferor deducts FMVInclude, (usually), fails DubersteinDeduct FMV, §162Problem 7: Gifts(a) Dolly, a dealer at a casino, receives “tokes” from players at her blackjack table. The players know that Dolly has no control over whether they won or lost (i.e. they know that she is not cheating on their behalf), but they give her the tokes because they believe that they will have good luck if they do. Are the tokes income to Dolly?Gift determined by dis-attached & disinterested generosityIf its like tipping a waiter, its income (because its in return of services)Real case dealer lostIt wasn’t disinterested generosity – it was an expectation of “good luck” – it was intensely interested (b) Does a subway busker (music player) who receives money from a train passenger have taxable income?Intent matters – we need to know why the train passenger paid the buskerIf they’re paying b/c they enjoy the music, its income not a gift and it is taxed(c) Target Co will be acquired by Buyer Co. Target Co. voluntarily pays long-time employees bonuses to reward them for their loyalty. The employees may keep the bonuses only if they remain with the company for one year after the acquisition. Are the bonuses income to the employees? What if the employees are permitted to keep the bonuses even if they do not remain with the company after the acquisition?Yes – they’re income (not §83 because its money and §83 is property as compensation )If they’re not required to stay it’s a harder case – turns on intent of transferor QUALIFIED SCHOLARSHIPSCode: § 117Textbook: 131-133Scholarships§117housing doesn’t count (can’t be deducted)qualified tuition reductions can’t discriminate in favor of highly compensated DAMAGE AWARDSCode: §§ 61(a)(4); 104(1)(2); 213(a)Textbook: 93-97Damage Awards §104 damages from physical injury are not taxable income (they’re exclusions)personal physical injuryphysical injury – IRS has not defined; 1 private letter ruling said you have to be able to see the injury;intended to be a bright line rule (eg exclude damages for defamation) emotional damages are includable in tax (doesn’t fit within this exclusion)periodic payments are excludableBook Problems p102 (p32 notes) Damages for past medical expenses can be excluded (flush language §104(a))Emotional damages (even if physical injury is req. to show emotional distress) are not excludableIf husband is killed and wife sues, wife can exclude because she’s a 3rd party making a claim based on her husband’s physical injury not a natural reading of the statute but the way cases have been decided. Legislative history says she’s not taxed on this. EMPLOYER-PROVIDED HEALTH INSIRANCECode: §§ 105(b); 106(a); 213(a)Textbook: 124-128Statutory Exclusions§106 – if your employer buys your insurance its not included in income§105 – if you get paid back for health insurance its not included in incomefringe benefits – benefits from your employer not in cashExampleAssume an employee & employer are taxed at 30%Assume subjectively, the employee prefers cash to the same $ amount of health insurance (discounted at 20%, eg. $100 health insurance, employee values at $80)Health Ins. (employee discounts by 20%)Type of CompensationCashTaxedExclude ins. (no tax)Amount (FMV)10010010087.50Cost to employer (deductible)10010010087.50Tax to employee at 30%303000After Tax Subjective value to employee70568070How much does employer have to pay employee in health insurance for the employee to feel the same benefit as paying $100 in cash70 = 0.8(x)x = 87.50now, both the employer & employee have an incentive for the payment to be in health insurance, not cashpurpose of deduction is to encourage employers to compensate employees in health insuranceOTHER EXCLUDABLE FRINGE BENEFITSCode: §§ 61(a)(1); 119; 132(a)-(f), (h)-(j)Regs: §§ 1.61-1(a), -2(d)(1); 1.132-2(a)-(c), -3(e), -4, -5(a)(1), -6, 1.119-1(a)(1), (2)Textbook: 208 (first paragraph), 217-220Packet: Benaglia v. Commissioner, 36 B.T.A. 838 (1987)Problem: 8Excludable Fringe BenefitsBenaglia v. IRS1937 (pre §119)Facts – Benaglia is manager of 3 hotels in Hawaii & lives on premises & gets meals for hotelIRS thinks room & board is includable incomeBenaglia says its excludableEmployment contract specifies the lodging (in dissent) in compensation its incomeMajority – for the convenience of employer, Bengalia needs to live thereAsk who benefits – Employer or EmployeeEnables taxpayer to do job more efficiently?ConsiderOptionality mattersIs it non-compensatory?Forced compensationReplaces necessary personal expenseEnriched? To what extent?If income, to whom?This rule is still the law – see §119No optionalityFor convenience of employerPrincipal justifying this ruleIts non-compensatoryIts forced compensationValuation problemIt doesn’t seem fair to include FMV if its much higher than what he would pay in rent otherwiseLiquidity problemPublic policy goals (we want employers to insure employees)Successful lobbying (Eg airline industry)5715004127500Excludable Fringefringe = non-cash benefitfringe’s are not always exempted, you need statutory authority to exempt itPROBLEM 8: Fringe BenefitsIn the following problems, which items should be included in gross income, and in what amounts?(a) Sarah, a summer associate at a law firm, receives the following benefits. Which items and what amounts should be included in gross income?(1) Her NYC income taxes are paid by the firm. Assume she earns $10,000 and the NYC tax rate is 2%its includable as income(2) On days when she works past 8:00pm, the firm:(i) reimburses her for the cost of a restaurant meal of up to $20 at a neighborhood restaurant.Our best shot at excluding is arguing it’s a de minimis fringe §132(a)(4) and (e)(1)The value must be low to employees after considering the frequency(ii) provides dinner, which is catered by a fancy French restaurant and served in the firm dining room. The dinner costs the firm $50 per person but is only worth $20 to Sarah.Excludable under §119(a)(1)Because meals furnished on premises and convenience of employer test is met (iii) Gives her $20 of supper money, of which she uses $10 to buy a sandwich and eat at her desk.You could argue de mimimis fringe if its infrequent and done at the convenience of the employer(iv) if she had the (highly unlikely option to choose between the catered dinner (scenario ii) and the supper money (scenario iii), how would the tax treatment affect her decision? What else would you need to know?Probably the dinner on premises is better because its more likely to be excludable (3) the firm also provides her with free parking in the building where the firm’s offices are located. The garage charges $1,000 per month to members of the public who park in the garage. What if the garage charges the public $100 per month?For the $1000 she can exclude $250 and include $750If the garage is $100 she can exclude the entirety (b) A commercial airline permits its employees and families to fly free on any scheduled flight on a standby basis. The airline also permits employees and their families to buy reserved-seat tickets at a 10% discount.(1) Bob, a flight attendant, and his wife Belinda fly free to Los Angeles for vacationBob’s flight is excluded, wife’s is excluded too (2) Bob buys discount tickets to Hawaii for himself and Belinda for vacation.Discount is excluded under §132(a)(2)(3) The airline’s policy permits top executives to fly first-class on a standby basis, while rank-and-file employees may only claim standby coach seats. Connie, the firm’s CEO, flies first-class to London also for vacation. No exclusion – if the benefit is discriminatory it must be included in incomeSample Multiple Choice Questions (p35 notes)DEDUCTIONSPERSONAL DEDUCTIONSINTRODUCTION TO PERSONAL DEDUCTIONSCode: §§ 62; 63; 67(a), (b); 68(a); 262Textbook: 363-366, 429-430Packet: Rev. Proc. 2014-61, secs. pertaining to assigned Code sections Deductionsabove + below the line (on the tax form (1040 ln 37)matters b/c below the line (itemized) deductions are generally subject to more limitationsabove the line deductions (not below) you get in addition to the standard deduction in §63(c) deductions reduce gross incomedeductions are only based on statutes (contrary to some common law exemptions); there must be a code sectionexemptions v deductionsexemptions aren’t written on the tax form (they conceptually happen in ln 7)but deductions are writtenboth exemptions and deductions are worth the amount of the exclusion/deduction x your marginal tax ratedeductions are subject to more regulation/limits than exemptionsexemptions + deductions have same rationalesaccurately capture incomepolicy incentives to effect behaviorequitable reasons (eg. we don’t want to tax someone crazy high on medical expenses)above the line deductions turn income into adjusted gross income (AGI)below the line deductions turn AGI into taxable income§62 defines AGI – this is how we know if the deduction is above the line or below the lineanything not listed in §62 is a below the line deductionyou get to chose between standard deduction (§63(c)) & itemized deduction (§63(d))57150012255500why have a standard deduction?Creates more progressivity in the tax system, to the extent the standard deduction overestimates expenses (and assuming most people who elect it do so because their itemized deduction would be less than the standard deduction)Simplicity for IRS + taxpayersAn itemized deduction is worth $0 to someone who elects to use the standard deductionItemized deductionsDisproportionately used by high income taxpayersNo list of itemized deductions; its defined in the negative; §62 has an exhausted list of above-the-line deductions (all other deductions are itemized)2/3 of taxpayer elect the standard deductionordering rule(1) apply limitations in statute that describe the deduction (Eg §221, §170)(2) apply 2% floor §67(3) apply 3% haircut §68miscellaneous itemized deductions (apply 2% floor)see §67negative definition2% floor – if your misc. itemized deductions are < 2% of AGI, you get $0 deduction; if your misc. itemized deductions are > 2% of AGI, you only get a deduction on $ over the first 2%EXAMPLE:2% floorAGI = 100,000Calc 2% = 2,000Suppose misc. deductions are $1999; you take $0Suppose misc. deductions are $2001; you take $1§67it shunts people into the standard deductionit can be a crude anti-fraud device (we grant above-the-line deductions to employer reimbursed business expenses (For example) because there’s a third party legitimating them; if they’re not, perhaps we’re a bit skeptical regarding their legitimacy)3% haircut, doesn’t apply to a lot of taxpayer; won’t apply on our examonly applies sometimesapplies to most itemized deductions; applies based on a taxpayer AGI, §68EXAMPLE:AGI – 350,000Applicable amount – 310,000Excess – 40,000Lesser = 3% of excess (1,200)3% of excess – 1,200itemized deduction – 50,00080% itemized deduction – 40,000applies only at very high AGImakes the tax code more progressive by removing itemized deductions for those with high AGItax increase (but stealthy + complicated) Personal Exemptions §151we know its below the ln (§151(a) says its to compute taxable income not AGI)phase-out for personal deduction (§151(d)(3)) – sneaky tax increaseyou get it whether you chose standard deduction or itemized deductionCHARITABLE CONTRIBUTIONSCode: §§ 170(a)-(d), (e)(1), (f)(3), (8); 501(c)(3), (4)Regs: § 1.170A-1(c), (g)Textbook: 366-368, 447-455, 465-469, 481-496Problem: 9Charitable Contributions §170orgs that countchurcheshospitalslaw schoolsfood banksoup kitchensymphony museum§170(a) gives authority to take deduction(b) is limitationsdeduction is limited to 50% of your contribution base §170(b)(1)(A) which is AGI pursuant to §170(b)(1)(G) for public charities in §170(b)(1)(A) – only applies to individualsother charities in §170(b)(1)(B) limit deductions to 30%corporations get stuck here because (A) is only for individualsif you donate more than top %, you carry forward §170(b)(1)(B)reasonstaxpayer chooses social program; puts money where mouth isencourages giving (not for tithing) for itemizers only (b/c if you don’t itemized you don’t get this deduction, you get the standard deduction)redistribution, privately (for some orgs)subsidizing community-building (maybe)measurement of ability to pay … BUT it is consumption (just like going to the movies)you can get pride, marketing, small favors (Eg tote bag from PBS), admissions, maintain value of degreebut QPQ (quid pro quo) is not deductiblesaves gov moneyform can be cash or propertyform cannot be in servicesbut expenses incurred in donating services can be deductedif you donate appreciated property – donor gets deduction on FMV (even though they were never taxed on increase of value of that property) – weird rulebelow the line deduction (itemized) (b/c its not listed in the exclusive list of above the line deductions in §62)§67 tells us which are misc. deductions (exclusive list, so if something is not included it is not a misc. deduction)§67(b)(4) sys charitable deduction is a non misc itemized deductiontherefore its not subject to 2% floor (§67)subject to 3% haircut assuming taxpayer meets AGI threshold contributions must be made to qualified charitable organization (§170(c)) for it to be deductible Bob Jones University v. U.S. (1983) (p482)facts/p.h. IRS makes a revenue ruling (states IRS’s position on a legal issue) that says schools that practice racial segregation are not entitled to tax exempt statusInterpreting §170(c) and §501(c)(3) (have identical language)Bob Jones pays tax (so it will have standing to challenge) & suesDist. Ct. (S.C.) (p484)(1) said IRS exceeded its administrative powers(2) violates free exercise clause Bob Jones’ religion prohibits interracial dating + marriage 4th cir – reverses says §170 & §501(c)(3) have to be read against background of charitable trust law & that req. that charitable orgs can’t be contrary to public policyD.C. circuit also issued a preliminary injunction prohibiting the IRS from according tax-exempt status to private schools that discriminated in rel. as to admissionS.C. Statutory interpretation goes beyond literal language if it would defeat plain purpose of statute (p486)Bob Jones argues for plain language b/c in §170 disjunctive “or” means that they can be tax exempt if they are religious or educational or charitable – meaning if the public policy must be met for “charitable”, then they should be one of the other “or” like educational Foreign revenue makes all taxpayers vicarious donors (p487) (a Surry arg)*** Usually – S.C. does not regard tax expenditures this way for const. interpretation (it would be a huge problem to do so)charitable means not in opposition to a clear public policy (p487)gloss on §170(c) & §501(c)(3)holding – IRS correctly interpreted the statutere FEC – applied to S.S. & this limit on rel. liability was justified by an overwhelming gov. interestDissentDisjunctive “or”Hernandez v. Commissioner (1989) (p449)factspetitioner is a member of the Church of Scientologypetitioner took “auditing classes” which was a religious requirement & cost $advance payment discountmust pay as a part of religious dogma (doctrine of exchange)refunds if you don’t use itchurch keeps trackchurch is tax exempt religious entity (§501(c)(3))Rule – no deduction to the extent of quid pro quo (QPQ)Petitioner argumentEven if its an exchange, what he gests is inherently religiousEqual treatment issue – other kind of quid pro quo in some other religions are permitted (dissent p454-55) (pew rental, tix to religious services)Arg here is EST CL violation – court is preferring some religions over othersMajority holding – it is proper to not permit the deduction because the quid pro quo is the entire worth of the auditingThere are other religious services that are not deductibleParochial schoolCounselingTake an all or nothing stance (doesn’t bifurcate religious part v. non religious part) b/c of fears of gov entanglement with religionDissent (p454)Administration of this rule is discriminatory – pew rentals, synagogue readings, etc. are wholly deductible (not just the part that’s not QPQ)After this case the IRS vacates itself and allows deductions for “auditing”Note – there is always some QPQProblem 9: Charitable ContributionsDescribe the tax consequences to the donor in each of the following scenarios:(a) Miranda donates $500 cash to Elite Academy, a prep school. The donation is pooled with two other contributions to buy a computer to be used by the 30 second graders, one of whom is Miranda’s daughter.You could add the donations and divide by 30 (and maybe by the kids next year)There is a QPQ but does it rise to a level that we want to reduce her deduction? – close call(b) Andrew donates $500 to the local soup kitchen. The donated amount is used to buy food for homeless men and women.Yes deduction(c) Allison spends $500 on bread, meat, and plastic bags, makes 600 sandwiches and passes them out to homeless people.No deduction (d) Josh donates one hour’s time providing legal work to a local tenant’s advocacy group. He usually charges $300 an hour for legal work. Shannon is another lawyer in Josh’s firm who also charges $300 an hour. She donates $300 cash to the same tenant’s advocacy group.Josh can’t deduct because it’s a serviceShannon can deduct because its cash (e) Ethan donates $500 to the World Faith Church. His donation entitles him to attend a Religious Education seminar held at the church, taught by a church member on “The Role of God in Western Philosophy.” The teacher teaches a similar course at the local community pare cost at college with the $500 Ethan paid, try to figure the extent of the benefit; figure out if its big enough (there’s a de minimis QPQ deduction rule in regs – tote bag rule)(f) Textbook, pp. 380-1, problems 1-3.Personal Deductionspersonal consumption usually not deductions; business consumption usually is a deductiondeductions require statutory authority (they’re a matter of legislative grace)*GENERAL RULE - §262(a) – no deductiontoday – we cover exceptions to that rule CASULTY LOSSESCode: §§ 165(a), (e), (h)Textbook: 401-412market, capital losses aren’t deducted until sale/realization§165 (losses) is an exception to the §262 rule against deductions §165(c)(3) – casualty losses – losses from fire, storm, shipwreck, or other casualty, or from theft sudden losses fit hereinterpretations in cases are pretty inconsistent (eg wedding ring cases)gross negligence exception to §165(c) has been read in; if you negligently tart a fire that burns down your house, you can’t get a casualty loss deductioncasualty losses justifications (for allowing deductions)ability to paynot consumption fairness/equitableinsurance (at amount of marginal tax rate)$100 casualty at 35% tax$350 value of deduction (value of insurance)could be seen as a substitute for other government spendingmoral hazardlook after your stuffdoes the insurance function discourage you from buying other insurance? And thus other taxpayers fund your insurance?But – marginal tax rate isn’t a lot compared to private outside insuranceAmount of insurance dependent on your marginal tax rate – insures the rich at a higher rateCasualty losses not listed in §62 so they’re below the line; not subject to §67 2% floorStatutory limits §165(h) – exceeds $100; exceeds 10% AGI (for all casualties added together)no deduction for capital losses, see §165(f)§165(e) theft lossPonzi scheme losses are theft loss, not capital losses (and therefore get better treatment)NON-BUSINESS INTEREST EXPENSECode: §§ 103(a), 163(a), (d), (h); 265(a)(2); 267(a)(2), (b)Textbook: 381-388Problem: 10Interest§162 trade/business expensesif interest is related to business – its deducted §162§163 interest§163(h) disallows deduction for personal interest§163(h)(2) exceptions – not limited to investment (?)home mortgage interest is deductible §163(h)(3)weird – we usually don’t allow deductions for investing in tax exempt assets (like homes)§163(d) – investment interest expense only taken to the extent of investment income casebook problems p384Paul v. Commissioner (p385)acquisition indebtedness v. home equity indebtednesssought deduction on 1.1Missue – can they separate?Total 1.1M1M acquisition indebtedness100K home equity indebtednessholding – no b/c §163 – term “acquisition indebtedness” and “home equity indebtedness” interpreted to preclude thiscourt sais home equity indebtedness cant include acquisition indebtednessso max deduction was on 1Mafter this case, IRS changed the rule and said you can deduct like thiscasebook problems p384-85max home equity indebtedness is 100K - §163(h)(3)(C)(ii)MEDICAL EXPENSESCode: §§ 105(a), (b), 106(a), 213Regs: §§ 1.213-1(a)(1); (e)(1)Textbook: 412-429Medical Care Expenses §21310% AGI floor before you can deduct any expensesyou have to itemize to get this deduction (same with casualty loss deduction)not subject to 2% floor or 3% haircutwhat is medical care?O’Donnabhain v. Commissioner (2010) (p417) (transgender case)Interpreting the meaning of medical care under §213(D)The “for the purpose of affecting any structure or function of the body” is limited to §2143(d)(9) – medical care often doesn’t cover cosmetic surgeryFacts – petitioner born genetic male, wants to deduct expenses for hormone therapy, sex reassignment surgery, & breast augmentation surgery due to her gender identity disorderIRS argues – GID is not a §213 “disease” within the meaning of the statuteThis is cosmetic surgery, not medical care because its aimed at appearanceDoctors aren’t in 100% agreement that GID is a diseasePetitioner doesn’t have a GIDHolding – petitioner gets to deduct these medical expenses except breast augmentation because it was cosmeticBreast augmentation expenses deductions were denied in this case, but not in all cases, because here it was cosmetic (p424)MISCELLANEOUS ITEMIZED DEDUCTIONSCode: § 67Textbook: 429-430BUSINESS EXPENSESORDINARY AND NECESSARY, TRADE OR BUSINESSCode: § 62(a)(1), (2); 162(a); 165(d); 183(a), (b); 212Textbook: 519-527personal expenses – usually not deductiblebusiness expenses – usually deductible to accurately reflect your income - §162Grotzingerwas his gambling a business or a hobby?Here – business b/c of factsDefinition of trade or business – Involved in activity w/ continuity + regularity; primary purpose for engaging is for profit or income; should not be a hobby, (but does not have to engage in activity full time)employees have a trade or business – their work§62 – employees take §162 deductions below the line (not above)if an employee’s expense is reimbursed by her employee it is deductible above the line (which is better)§62(a)(2)(A)is it a business expense?Ordinary and necessary?Necessary = appropriate + helpfulOrdinary (two meanings):(1) customary in trade(2) not a capital expenseif its not a trade or business but it is for production of income – see §212still must be ordinary and necessarynecessaryPalo Alto Town & Country Village, Inc. v. Commissioner (1978) (p521)Facts – taxpayer has a plane on standby 24/7 and deducts that amount. Gov says you can only deduct the costs of your trips, not the standby feesIssue – are standby costs ordinary + necessary expenses?9th Cir holding – necessary – low standard; appropriate and helpful – expense does not have to be essential(ordinary – normally expected in this situation)holding – its deductiblefact specificOrdinaryordinary has two meaningscurrent expense customary; not extraordinary; typicalWelchNot ordinary to pay a debt you don’t owe (but it is necessary b/c its appropriate and helpful)Commissioner v. Heiniger (1943) (p523)Facts – dentist made false teeth sold by mail. Accusation he’s making fraudulent claims & post office stops delivering his mail. He sues post office & deducts legal expensesIssue – can he deduct his legal fees incurred to defend against this fraud claim?Necessary?Yes because its appropriate and helpfulOrdinary?Court says we can expect this of any taxpayer, that if business is under attack you would defendIts normal behaviorI think he got the deductionPublic policy undertones – issue with fraudGilliamArtist flying to show assaults a passenger & wants to deduct legal expensesHolding – not a business expense because assault is not related to trade/businessPUBLIC POLICY LIMITATIONSCode: §§ 162(c), (f), (g); 280ERegs: §§ 1.61-3(a); 1.162-1(a)Textbook: 533-547Problem: 11Problem 11: Public Policy Limits on Business Expense Deductions(a) Joey owns a bookstore in a rough neighborhood. Local thugs (hired by a large chain bookstore, unbeknownst to Joey) demand weekly payments from Joey in exchange for letting him remain in business.(1) assuming a deduction for these payments would not be denied under section 162(c)(2), are the payments “ordinary and necessary” under section 162(a)?necessary = appropriate and helpful (and not against public policy)ordinary = capital v. current = seems current (like rent)customary in trade = probably depends on time/place/normalcycases of kick backs to contractors normally allow the deduction(2) are the payments deductible under Section 162(c)(2)?If this payment to thugs is illegal & joey’s payment would subject him to criminal prosecution & if its in violation of a state law that’s regularly enforced or any federal law, then he does not get a deduction – see §162(c)(2)(3) What if Joey had to make payments to the police as well? Would those payments be deductible?No deduction §162(c)(1)(b) Frank was convicted of fraud for selling dubious legal schemes to low income taxpayers. The court ordered him to pay restitution to his victims in order to stay out of prison. May Frank deduct these restitution payments under Section 162?Frank can deduct – restitution payments do have a punitive quality, but §162(f) says fines are only fines if paid to the government Tank Truck Rentals, Inc. v. Commissioner (1958) (p534)facts – PA had low weight requirement for trucks with a fine for going over. (substantially could be argued it’s a toll). It was only commercially viable to have higher weight for trucks. They violate the law intentionally & they get some fines. They deduct their finesissue – are the fines deductible as ordinary & necessary business expensesholding – no; even if ordinary, we won’t allow deductions when contrary to public policy because its not necessary. Necessary – appropriate and helpful and not frustrated by sharply defined public policyTest for non-deductibility – is the severity & immediacy of the frustration resulting from allowance of the deduction …frustration of state policy is most complete and direct when the expenditure for which deduction is sought is itself prohibited by statute (p536)§162(f) – passed after Tank Truck – so now they couldn’t deduct the penalty question – is there still a general public policy exception to §162?Treasury’s view – statute §162(c) & (f) are exhaustive – if not explicitly listed, then its deductibleReg §1.162-1(a) – treasury says not to read in public policy limitsBUT – courts do bring in public policy limits under “ordinary and necessary” interpretationLegal bribes & kickbacks go both ways (under regs they should be deductible)Examplescan a drug dealer deduct advertising expenses?See §280ENoCalifornians Helping to Alleviate Medical Problems, Inc. v. Commissioner (2007) (p540)Facts – organization provides caregiving services and medical marijuana. Patrons pay a fee that includes bothIssue – are expenses deductible? Or are deductions denied under §280E??Medical marijuana legal in CA but not in federal law; §280E refers to federal lawHolding – expenses for medical marijuana denied as deductible under §280ECourt divides into 2 trades/businessesAll expenses related to caregiving (provided ordinary and necessary) are deducibleFor medical marijuana labor related to and costs of goods sold are deductible; other related expenses to marijuana are not deductibleNote – costs of goods sold are always deductible, even under §280E (in legis. History due to fear of constitutional problem because authorization of income tax)LIMITATIONS ON COMPENSATIONCode: §§162(a)(1), (m)(1), (3), (4)(A), (C), skim §§ 1(h)(1)(C), (3)(B), (11), 11(a), (b)Regs: §§ 1.162-7, -8Textbook: 550-558Problem: 12DividendSalaryCorp GI1,000,0001,000,000Deduction for salary(0)(1,000,000)Corp AGI1,000,0000Corp tax @ 34%340,0000Dividend660,0000Salary01,000,000Shareholder tax @ 15%100,000n/aEmployee tax @ 35%n/a(350,000)Amount after all tax570,000650,000*if the corporation ^ has only one employee, they’re better off getting a salary rather than a dividend fear of abuse due to this in closely held corporationsthis example ^ is becausecorporation income is taxed 1x when earned and 1x when distributed to the shareholderwhen corp. income is distributed as salaries to employee – it is not taxed by the corp., only by the individualExacto Spring Corp. v. Commissioner (1999) (p552)Facts – Heitz gets paid 1.3M and 1.0M in 2 years described as salary. Commissioner argues its excessive and they should pay 380K. Tax court below said he should be paid 700K and 900KIssue – is this salary or dividend? Any $ we say is not a salary is dividend that is subject to corp. tax and tax when distributed to shareholders as a dividend.Lower tax court – applies 7 factor test. Most factors come out in favor of Heitz, yet tax court comes out on side of commissioner. Posner – gets rid of 7 factor test implements “independent investor” test. What return should investors respect?Applied – shareholders should expect 13% return. Shareholders did get 20% return so Heitz did a great job and his salary is presumptively reasonable unless you can show bad intentPresumptively reasonable salary when profitability is higher than expectedHow to calculate expected return for shareholders? (here they used IRS expert p554) could look to prevailing market return or could look to set statutory # this is a problem we don’t know how to calculate thisThese cases turn on their facts & they’re hard if you use either testIn publicly held corp. when compensation is too high, deductions for excessive salary is not allowedsee §162(m)if you pay more than $1M, the excess is non-deductibleexceptions - §162(m)(4)(B)-(C) – performance based salaries (bonuses) are excepted from this rule problem 12: Reasonable CompensationFive years ago, Tonka Corp., a closely held corporation, was on the verge of bankruptcy. Robert, the principal shareholder, convinced Nick, his son, to leave his job at a bank and take over as president of the family business. Nick’s contract with Tonka Corp provided him with a salary of $200,000 per year, plus 20% of the profits for the next five years. During Nick’s first four years with the company, Tonka Corp did not show a profit, but this year, Tonka Corp had profits of $5 million. Nick therefore received $1.2 million salary this year – his regular $200,000, plus 20% of $5 million.(a) is the additional $1 million deductible by Tonka Corp?issue – is it a salary or a dividend (to the father followed by a gift from the father to the son)?If it’s a disguised dividend, its not deductible by Tonka(b) Assume that in addition to entering into the employment contract, Nick also purchased a 10% interest in the company. Does it matter to Nick whether the $1 million is salary or a dividend? Does it matter to Tonka Corp?Yes. If it’s a salary its taxed higher for Nick than if it’s a divided. For Tonka, salaries are deductible, dividends are not because they’re a closely held corporation. They may be better off paying salaries & being taxed one time, not twice. BUSINESS VS. PERSONALTRAVEL, MEALS, LODGING, ENTERTAINMENT, CLOTHINGCode: §§ 62(a)(1), (a)(2)(C), (c); 162(a)(1)-(2); 274(a), (b), (d), (e), (k), (n)Regs: § 1.162-2(a), (b), -6Textbook: 558-568; 595-599Problem: 13Business v. PersonalPevsner v. CommissionerFacts – P works at YSL and has to wear YSL clothes at work. P deducts costs of her clothing $1400 and IRS doesn’t want her to deduct. P says she only wears clothes at work because they don’t suit her lifestyleIssue – can she deduct – how to interpret prong (2)Donnelly 3 factor test(1) type of clothes condition of employment(2) not adaptable to general usage as ordinary clothing if it’s a uniform you get a deduction(3) not worn outside workGov argues (2) is an objective standard more administrableTaxpayer argues (2) is a subjective, “as applied” standardRule – objective test; no deduction for PStandard – “can the item be worn outside work”So basically only uniforms and special safety equipment are deductedHartzis v. Commissioner (1981) (p561)Law student summers in NYIssue – can she deduct, under §162(a)(2) her lodging expenses in NY as a travel expenseTP argues – home means homeIRS argues – home means work (“tax home” = where you work)No non-personal reason for her to go back to BostonHolding – no deductionA married couple can have two tax homes* for §162 home = where you work* you can deduct expenses for temporary traveling expenses for business (anticipated <1 year)meals§162 & §274 (limits on deductions)assuming its ordinary and necessary business expense, employers can deduct mealsfor deduction, meal has to be associated with trade/business. No deduction for entertainment facilities §274§274 raises the standard higher than ordinary and necessarymeals are only 50% deductible to employer §274(n)exceptionsemployer can elect to include employee in income & then they can deduct 100% (practically they don’t)if it’s a §162 meal, the employee can exclude 100% mealproblem 13: Mixed Business and Personal Expenses, Travel and Entertainment(a) Frank is a secretary at X Corp. He brings his lunch to work every day and eats with his colleagues in the break room, where they often discuss work. Arthur is the president of X Corp. He eats lunch at an expensive restaurant every day with the X Corp officers; they are often joined by a client, an attorney, or an accountant. Arthur’s lunch expenses come to $10,000 for the year and are not reimbursed by X Corp. Although Arthur and his lunch companions do not discuss specific business issues at lunch, they do discuss general business related matters, such as economic conditions and industry-wide problems. Who can deduct what? Does anyone have any income?Frank cannot deduct cost of his meal because he doesn’t meet the high standard in §274 Arthur maybe can if its not lavish?(b) Ursula is an associate in the tax department of a large law firm. She pays for the following items. Which can she deduct?(1) The costs of suits, blouses, dress shoes, etc., that she is required to wear in the office. She hates all of these clothes and never wears them when she is not at the office.No deduction(2) The cost of a private car service that picks her up at home each morning, takes her to work, and returns her each evening. She works during the entire ride, using her cell phone and laptop.No deduction(3) Dues to the Young Lawyers’ Networking section of the American Bar Association.Yes deduction (withdrawn §1.162-6 reg indicates this ) §162 ordinary and necessary business expense(c) How does her tax treatment differ, if at all, if her law firm pays for the above expenses directly? What if she pays the expense and the firm reimburses her?(a) frank can’t deduct the cost of his mealsArthur, if he weren’t reimbursed by his employer probably doesn’t qualify under §274 because his discussions are not specified. If he took out a client his argument would be stronger. Even when deductible, only 50% is deductible under §274(n).If instead of reimbursing him, Arthur’s employee directly paid for his lunch, it’s the company’s expense (and assuming the meal is directly related to the business discussion standard under §274) the corporation can deduct 50% of the expense. In this case Arthur can exclude the whole meal expense when the employer buys the meal, as long as it’s a working condition fringe (otherwise deductible by you)EDUCATIONCode: § 117(a)Regs: §§ 1.162-5Textbook: 131-133, 584-589Problem: 14business/personal distinctionwhat we’re worried about w/ mealsalso comes into play with educationcurrent/capital distinctionanother issue with educationEducation Expensesno deductionno capitalization & rated deduction over time§162; Reg. §1.162-5no deduction if you’re qualifying for a new trade/business - §1.162-5(b)(3)rule – education is deductible if (p588)(a) it maintains or improves skills required by the individual in his employment or other trade or business – OR – (b) it must meet the express requirements of the individual’s employer or applicable licensing regulations imposed as a condition to the retention of the individual’s stats– BUT NEITHER – (c) (it must not) meet the minimum entry-level requirements for qualification in the particular trade or business the taxpayer is entering – NOR – (d) the education must (not) qualify the taxpayer for a new trade or businesseducation is mixed personal/business and mixed current/capital but the “compromise” in the regs is to entirely deny deductions for (initial) educationto be deductible, education must:(a) maintain or improve skills required by taxpayer in T/B OR (b) meet express, bona fide requirements of employer, law, regs, etc.AND MUST NOT(c) be necessary to meet minimum educational requirement for employers T/B(d) qualify taxpayer for a new T/BNamrow v. Commissioner (1961) (p584)Facts – Namrow was a psychologist and wanted further certification in psychoanalysis. Namrow wants to deduct the expenses incurred for this certification. Goal – get referrals in psychoanalysis (through meeting people at the institute). So there is a profit motive in incurring the expenseIssue – is this a business expense?Holding – not deductible b/c psychoanalysis is a different T/B than psychologyNote – no longer good law – treasury reversed this case by noting that psychology/psychoanalysis is the same T/B in the regsCLE courses are maintenance & therefore deductible Problem 14: Mixed Business and Personal Expense’s, EducationIn which, if any, of the following scenarios can you deduct the tuition for an LLM in Taxation degree at Surrey School of Law?(a) when you graduate from UVA, you go immediately into the full-time tax LLM program at Surrey, after which you obtain a job as a tax associate at a large law firm.No deduction – you don’t have a t/b yet (and its not maintenance until you do)(b) When you graduate from UVA, you take a job as a tax associate at a large law firm. The law firm tells you that in order to keep your job, you must get a tax LLM within three years. You enter the part-time tax LLM program at Surrey, attending classes at night and working during the day.Argument for deduction – minimum requirement is JD, and LLM is maintenance only(c) When you graduate from UVA, you take a job as a tax associate at a large law firm. The law firm doesn’t say anything about whether you should or should not get a tax LLM, but your love for tax drives you to enter the part-time tax LLM program at Surrey.Yes deduction – weird, but the way the regs work with respect to education/teaching(d) When you graduate from UVA, you want to become a tax associate. The law firm that hires you tells you that you have to start out as a corporate associate, but if you get your tax LLM, you can move to the tax department. You accept their offer and take the job as a corporate associate, but you enter a part-time tax LLM program at Surrey to fulfill your dream of becoming a tax associateyes deduction b/c minimum requirement is JD, and the LLM is maintenance. Argument is that practicing law is the t/b, and moving within practice groups is not a movement of t/bEducationhope credit for first 4 years of collegelifetime learning credityou cant claim a credit for the same expense you deductdeductions (we missed earlier in class)savings incentivesstate/local property taxes (§164)not included in income baseimputed income = anything not in 7-22 or 1040 formunrealized incomeanything excluded (eg gifts)TIMINGANNUAL ACCOUNTINGBACKGROUND: ANNUAL ACCOUNTINGCode: §§ 172(a), (b)(1)(A), (c)Textbook: 139-143MISTAKEN DEDUCTIONS: § 111 and the Tax Benefit RuleCode: § 111(a)Regs: § 1.111-1(a)(2)Textbook: 78-81; 175-182 (skip Note 6, p179)Problem: 15Tax Benefit (mistaken deduction) Rule(1) Deduction in year 1, and(2) deduction actually reduced tax liability in year 1 (i.e. taxpayer received a tax benefit), and (3) in a later year, taxpayer recovers the deducted expense (eg state tax refund), then(4) in year of recovery, taxpayer includes income, but only to the extent the mistaken deduction provided a tax benefit (i.e. reduced taxpayers income in year 1)tax is about amount, timing, sourceperiodic annual accounting§441 – authority for annual accounting periodrationalescompliancegovernment needs regular revenueproduces harsh results because no such thing as negative taxes (no refunds for losses) + progressive taxesso if you have sharp ups and downs over a number of years, you’ll pay more than if you earned the same amount but in a steady stream each yearEXAMPLE:Year 1Year 2Year 3TotalTaxpayer 1$40$40$40$120Taxpayer 2$0$0$120$120Taxpayer 2 ^ is taxed at a higher rate b/c $120 is in a higher bracket than $40Our tax system is generally non-refundableLimited relief from harsh results due to net operating loss carry forward and carry back§172 – net operating loss deductionif you have an overall loss, you can carry it forward 20 years and backwards 2 years§441 – you can choose when your taxable year beginsallows you to more closely align your expense with revenuesbut individuals have to use calendar yearmistaken deduction (tax benefit)authority is long administrative practice & judicial (supreme court) approvalits income – look to §61unclear authority though (its not specified)Hilsboro National Bank v. Commissioner (1983) (p175)§111in mistaken deduction – you don’t get the benefit of the higher rateMistaken deduction rule does not take account of interestProblem 15: Mistaken DeductionsIn May of year 2, Gail received a $500 refund from New York on account of state income taxes that had been withheld during Year 1 in excess of her state tax liability for Year 1. In each of the following situations, will Gail be required to report income on account of the refunded state taxes? If so, when and in what amount? (See §111; Reg. §1.111-1(a))(a) Gail didn’t itemize her deductions in Year 1; instead she took the standard deductionno inclusion because no deduction in year 1 – so she had no benefit in year 1(b) Gail did itemize her deductions in Year 1 (including the state income taxes withheld by her employer). In the aggregate, Gail’s itemized deductions exceeded the standard deduction by many thousands of dollars.Yes, she must include income of $500 (full amount)(c) Gail did itemize her deductions in Year 1. Her only itemized deduction was $5,000 of state income taxes withheld by her employer in Year 1. The standard deduction for which she was eligible was $4,700.Yes, she must include $300 income ($5000 - $4700) which is the measure of her tax benefit at the current tax rate (no matter what)MISTAKEN INCLUSIONS: § 1341 AND THE CLAIM OF RIGHT DOCTRINECode: 1341(a)Textbook: 179-180 (Note 6 only)Problem: 16response of tax system to mistakes when the year is closedclaim of right = mistaken inclusion into income which you paid taxes on (turns out you didn’t have income)correct by taking a deduction in the subsequent yearauthority unclear – could be §162 ordinary and necessary business. But there is authority for taking deduction §1341 tells you how to do it, we just don’t know the exact authority (but we know it exists)no interest payment but you can take it at the year with the higher tax rate (if your deduction exceeds $3000 – see §1341(a)(3))no time limit on when the mistaken inclusion is foundneither the mistaken inclusion nor the mistaken deduction rule take account of interestmistaken interest rule accounts for differences in rates, but the mistaken deduction rule does notProblem 16: Mistaken InclusionsGilbert, a cash-method taxpayer, receives a bonus of $10,000 from his employer in a tax year when his marginal tax rate is 30%. The next year his employer realizes that in fact Gilbert had not met the benchmark required to earn a bonus, and Gilbert repays the $10,000. In the year in which Gilbert repays the $10,000, his marginal tax rate is 15%.(a) What is Gilbert’s tax treatment under section 1341?Year 1Inclusion10K@ 30%3K tax Year 2Deduction10K@ 15%1.5K tax benefit???(b) What if Gilbert is in the 35% bracket in the year of repayment?(c) What if Gilbert’s marginal rate bracket in both years is the same?TAX ACCOUNTINGCASH METHODCode: §§ 267(a)(2), (b)(1), (c)(4); 446; 448(a), (b)(3), (c)(1); 451(a); 461(a)Regs: §§ 1.162-11(a); 1.263(a)-4(d)(3), (f)(1), 1.451-1(a)’ 1.451-2, 1.461-1(a)(1)Textbook: 661-662, 672-673Problem: 17Cash accounting §1.446-1(c)(1)(i)include when actually or constructively receiveddeduct when actually paid (unless you have to capitalize) see also §1.461-1(a)(1)2 kinds of accounting(1) tax & (2) bookgoal – give shareholders an accurate view of a company’s income (of accounting rules)cash accounting simplerless accuratethere’s no such thing as constructive paying for a cash method taxpayerwho uses which methodwith some exceptions, the taxpayer choosesyou use the dame method you keep books with to pay takes withmethod must clearly reflect incomeif not, the commissioner can require you to use other methodif income derives from inventory, you must use accrual method, unless gross receipts <5Mproblem 1 (p662)rule – included when paid §267(2)if you’re related, the code requires matching of deduction and inclusionCash Accountingconstructive receipt – when payment is set aside for him, credited to his account, or otherwise made available to himold rev rule says notice is not required (think bonuses always paid Dec 31)judicial authority says notice is required for constructive receiptcant be subject to substantial limitations for it to be constructive receiptchecks normally considered to be constructive receipt even if you haven’t cashed it deductions under the cash accounting methodtaxpayer should take deduction pursuant to method of accounting mailing a check is payment & you can deduct a promise to pay is not a payment & you can’t deductif you pay with a credit card you can deduct (even if you don’t pay it off for years in the future)problem 17: Tax Accounting Under the Cash MethodJoe, a tax lawyer, provides $500 worth of tax advice to Sam in October of Year 1. Both Joe and Sam use the cash method of accounting. In each of the below scenarios, explain in which year Joe must include income and in which year Sam may take a deduction (assume for purposes of this problem that Sam’s payment is in fact deductible)(a) Sam pays Joe $500 cash in December of Year 1Joe includes yr 1Sam deducts yr 1(b) Joe sends Sam a bill in December of Year 1, and Sam pays Joe $500 cash in January of Year 2Joe includes yr 2Sam deducts yr 2(c) Sam gives Joe a $500 check in December of Year 1, but Joe does not cash the check until January of Year 2Joe includes yr 1 (constructive receipt)Sam deducts yr 1(d) Sam calls Joe in December of Year 1 and says, “Hey, I have $500 here for you, as payment for your tax advice.” Joe does not come to get the $500 until January of Year 2Joe includes yr 1Sam deducts yr 2(e) Joe does not send Sam a bill until January of Year 2, at which point Sam gives Joe $500 cashJoe includes yr 2 – Joe defers his income to yr 2 by billing in yr 2Sam deducts yr 2(f) Sam pays Joe $500 using a credit card in December of Year 1, but Sam does not pay his credit card bill until January of Year 2Joe includes yr 1Sam deducts yr 1ACCRUAL METHODCode: § 446, 451(a), 461(a), (h)Regs: §§ 1.451-1(a); 1.446-1(c)(1)(ii)(C); 1.461-1(a)(2); 1.461-4(g)(1), (2)Textbook: 675-681Problem: 18Accrual Accounting §1.446-1(c)(1)(ii)include when all events have occurred that:(1) fix the right to receive the amount and earliest of when paid, due or earned (service performed, property delivered)rev proc 2004-34rev proc 74-607(2) the amount can be determined with reasonable accuracy[(3) economic performance has occurred §1.461-4(g)]i.e. when services/property delivered to taxpayer §1.461-4(d)(2)note – only required for deduction, not inclusionAccrual accounting for TaxTreasury reg §1.461-1(a)(2)Deduct when “all events” have occurred that:(1) establish the fact of the liability(2) the amount can be determined with reasonable accuracy(3) economic performance has occurredtreasury reg §1.461-41(g) describes exceptions, deduct only when paidtort payment is an exception to the rule (rebates, refunds)attempts to match income + expensesC corp with gross receipts >5M must use accrual accounting “all events” test is a facts & circumstances testif payment is under contention, the part that is not under contention is includable Mooney Aircraft, Inc. v. U.S. (1969) (mentioned p679)Mooney sells planes & bond $1000 when airplane is retired (expected in 20 years) “Mooney Bond”In year 1 (year of sale) Mooney deducts $1000 – BUT the cost of paying $1000 in 20 years is not $1000 today – it should be discounted based on TVMMooney, by deducting in full today, is overstating his deductionCourt says – Mooney can only deduct when he actually pays the $1000 (he cant even deduct the amount he needs to invest today to have $1000 in 20 years)Ford Motor Co. v. Commissioner (1995) (p675)Ford has tort settlements$24M – expected payments over a very long periodto cover that cost they buy an annuity cost $4Moriginally they deduct $10M based on all fixed costs they must pay. Commissioner says they’ve made an error & so Ford says they should deduct $24M gov argues under §446 Ford’s method of accounting (accrual), does not clearly reflect income & instead they should deduct $4M cost of annuity now & in respect to the future payments not get any deductions as you go (b/c the annuity will generate $ to pay it off and you’ve already deducted the cost of the annuity)holding – IRS has authority to restate the income under §446just because you’ve met the “all events” test, that’s not enough – you must meet the separate requirement of clearly reflecting incomeunder current 461-4(g), Ford can’t deduct the 4M. They must wait until they pay the tort victims before they can deductnow – see Reg. §1.461-4(g)(8)(Example 1)regulatory response to Problem 18: Tax Accounting Under the Accrual Method(a) for each of the scenarios described in the last problem, in which year Joe must include income and in which year Sam may take a deduction if Joe and Sam both use the accrual method of accounting?(a) Joe includes yr 1; Sam deducts yr 1(b) Joe includes yr 1; Sam deducts yr 1(c) Joe includes yr 1; Sam deducts yr 1(d) Joe includes yr 1; Sam deducts yr 1(e) Joe includes yr 1; Sam deducts yr ?(f) Joe includes yr 1; Sam deducts yr?(b) Thomas is an accrual method taxpayer. In each of the below scenarios, in which year may Thomas take a deduction (assume for purposes of this problem that each of these payments is in fact deductible).(1) Thomas pays $500 for pencils in Year 1. The pencils are delivered in Year 2.Deduct in year 2, because no economic performance in year 1(2) Thomas rents office space and prepays a year’s worth of rent in Year 1 for a lease that starts in January 1 of Year 2. He moves into the office on January 1 of Year 2.Deduct in year 1 - §461(h)(2)(A)(iii) – generally no deduction for prepayment of rent, but regs allow you to prepay 1 year of rent(3) Thomas owes $500 in state taxes for income earned in Year 1. His tax bill is due on December 1 of Year 1. He pays his tax bill on January 15 of Year 2. Year 2 – taxes are a special exception where you don’t take the deduction until you pay §1.461-4(g)…ECONOMIC ACCRUALCode: §§ 1272(a)(1)-(5), (d)(2); 1273(a), (b); 1275(a)(1)(A); 163(e)(1)-(2)Regs: § 1.1272-1(b)(1), (g)Textbook: 349-352Problem: 19AbbreviationsOID – original interest discountIP – issue priceSRPM – stated redemption price at maturity(r) – it’s the implicit interest rate, compounds semi-annually by defaultYTM – yield to maturityt – time, # of compounding periodsQSI – qualified stated interest (any $ you actually get that year)(1) Total OID = SRPM – IP(2) YTM = yield to maturityFV = PV (1 + r)tSRPM = 1P (1 + YTM)tSRPM = 1P (1 + YTM)years + 2(3) AIP = adjusted issue price. At the end of period, AIP is AIP at beginning of period plus OID included in that period(4) AIP x YTM – QSI = OID included in each periodstep 1 – determine amount of OIDstep 2 – determine YTM (for us, its given)step 3 – determine accrual periods (default, semi-annual)step 4 – determine OID included in each period noteissuer (on accrual method) = debater = company (usually)holder (on cash method) = lender = natural personinteresteveryone has to include interest as it accrues, no matter their accounting methodbefore OID rulewhen accrual method companies borrowed from cash method individuals, borrowing company deducted unstated interest annually, but individual lender didn’t include income for that interest until they received $ at the maturity of the loan. This was a timing whipsaw.LessonsWhere complexity comes fromResponds to tax avoidance techniquesSubstance over formParties write security to say no interest, but tax system realizes there is interest and imputes steady interest over life of loanImportance of matchingTo prevent whipsaw, we may require matching of inclusion and deductionImportance of TVM§1272 – include imputed interest§1272(d)(2) allows lender to increase basis in bond after he pays interestbasis = AIP + OID included in each period§163(e) – issuers deduction match REVIEW AND PREVIEW OF TIMING ISSUESTAXATION AND THE FAMILYCHILDREN AND TAXATIONCode: §§ 21; 24; 129; 132(a)(3), (d); 151; 152(a)-(c), (f)(1)-(2), (5); 162(a); 262(a)Textbook: 757-767, 794-806Packet: Smith v. Commissioner, 40 B.T.A. 1038 (1939); Rev. Proc. 2014-61, section pertaining to assigned Code sections.Problem: 20MrMrsChildrenImputed Income from ChildcareChildcare costsNet Economic IncomeTaxable IncomeSterling$50,000$50,000Y020,00080,000100,000Cooper$10,000$0Y20,0000120,000100,000Draper$100,000$0N00100,000100,000Price$50,000$50,000N00100,000100,000Options for childcare expensesdo nothingfamilytax treatment of childcare expensesare childcare expenses personal?One effect of not allowing a deduction for childcare costs is that it is less valuable for the second spouse to go into the marketplaceAre kids expensesPersonal consumption?Business expenses?A social good?Childcare as business expenses§21 child care credit§129 dependent care assistance programskids reduce your ATP, whether or not both parents work / natalism§151 dependency exemption§24 child tax credithead of household filing status Smith v. IRS (1939) (packet)smith couple hires nursemaid to care for their child because they’re both employed. They argue that “but for” the nurse the wife could not work outside the home. They argue that this is a new business expense because now two parents are working court says – wife’s work at home is rendered without compensation & has no taxable income. The wife chose to offset her home duties by hiring someone & so she doesn’t get a deductionholding – this is not an ordinary and necessary business expense and therefore no deduction Symes v. Canada (1993) (p794) Canadian casefacts – Symes is a law partner. She hires a nanny for her children & deducts it as a business expense. Revenue Canada (IRS) reduces thiscourt goes through mixed business/personal expensescourt acknowledges they are “but for” expenses, but says childcare needs are independent of the job majority doesn’t decide on this basis – they decide the case on a statutory basis statutorytalk about language of §63 & says child care deduction exists & because it exists, they can’t deduct under §9 as business expense the only way Canadians can deduct childcare is under §63charter (equal protection)no inequality because §63 doesn’t establish an inequality because no evidence that women disproportionately pay childcare expenses (even though women disproportionately bear social costs of childcare)MARRIAGE AND TAXATIONCode: §§ 1(a), (c), (d), (f); 2; 7703Textbook: 767-781, 810-817, 356-358Packet: Rev. Rul, 2013-17 IncomeTaxAaron (single)800Betty (single)00A+B (married, brackets don’t change)8014.5A+B (married, brackets doubled)807 – Marriage BONISCarl (single)403.5Donna (single)403.5Carl + Donna (married, brackets don’t change8014.5 – Marriage PENALTYCarl + Donna (married, brackets double)807standard deduction – 5K per personincome – 0-40 taxed @ 10%income over 40 taxed @ 30%EXAMPLE ^option 1 – brackets don’t change (when married)option 2 – brackets double (when married)or something in between (what we do)the greatest penalties are suffered by couples that earn the same amount. The greatest bonuses are granted to single earner couples (unequal earners)Lucas v. Earl (1930) (p767)facts – Mr. & Mrs. Earl signed a contract saying all of their earnings, etc. are joint property. Then they divided Mr. Earl’s income in half and each paid taxes on ? (paying 2x as much in the low bracket). note – this was before married couples could file jointlycourt says – all income must be taxed as Mr. Earl’s income. The income is earned by Mr. Earl & taxed & then ? is transferred to Mrs. Earl (as a non-deductible/non-includable gift)no self help income splittingPoe v. Seaborn (1930) (p769)facts – Mr. Seaborn earns income outside the house & property of real estate, stocks, etc. Mr & Mrs. Seaborn each paid taxes on ? of the incomedifference between Poe v. Seaborn & Lucas v. Earlhere sharing is by operation of law – they live in community property law – there’s no transfer from husband to wife, automatically at all time ? is owned by eachin Lucas v. Earl, the sharing is due to a private contractIRS arguesEven though the property is jointly owned, the husband is in control so he should pay 100% taxesCourt – says both spouses own the incomeResult – you can only get the benefit of income shifting in community property states, so states start shifting to community property regimesInstead of requiring everyone to shift, the fed. gov. decided to allow joint filing. Drutgers (1983) 2nd cir casearg marriage penalty violated EPC by discriminating against married couples. Court held the penalty was too indirect to be an EPC violation. Court denied. Marriage penalties You cant treat married & singles alike in a progressive tax system, so you could fix it by eliminating progressivity & make it a flat taxMarriage penalties occur any time the married brackets are <2x the width of the single bracketsNo marriage penalties for first 2 columns on marriage penalties doc (see handout)Married filing separately gives you no advantage over married filing jointly. Filing separately is always ? filing jointlyThings phase out faster for married couples than for singlesEg earned income tax creditMany kids related benefits are biggest for the first kidIf you’re not married for tax purposes (bad consequences) Not entitled to estate tax exemptionCan’t get exemption for fringe benefits for spouseBoyders caseFacts – Lived in MD, married. At end of year they get divorced in Haiti/Dominican republic & in January they get married again. They do this 2x only to get avoidance of tax penaltiesIssue Fed question – is there a sham here? Sham transaction doctrine?Court looks at reality of situationMarriage & divorce & re-marriage = marriageSubstantively they never got divorcedAnalogy – corporate tax – liquidation & reincorporationState question – does MD recognize divorces from Haiti/Dominican republic?If this answer is no, they were not qualified to file separatelyGov wins if it wins either of these issues4th cir remands on fed questiondissent – by remanding, the court skips the question, if the tax system must follow the state court’s determination if the divorce is validFederal Tax Purposesmarriage determined by state lawWindsor – same sex marriage valid in state you get married in, then you’re married for tax purposesPre-Windsor DOMA didn’t allow this – said fed law won’t allow same-sex marriage, even if states recognize it2013-7rev ruling is agency’s reaction to Windsorall federal tax rules apply to all married couples – marriage determined by state law (same or opposite sex)decision same as common law marriagemarriage for state law purposes even w/o formal recognitionif you’re common law married, fed tax recognizes as married. If you move somewhere w/o common law marriage, for tax purposes you’re still married based on state of solemnizationwhat we care about is state of solemnization, not the state of residencereasoningadministrative easefor tax authorityemployerstaxpayersgender neutrality is not precluded in terms of the tax codedictionary act – 1 U.S.C. § 1 – p7 rev rulhe = s/he§7701 – husband = husband/wifeno indication that congress is subdividing marriage – congress just wants to make marriage 1 big categoryIRS doesn’t collect gender info so it would make it hard for IRS to police same sex marriageWe should avoid conflicts in the law – avoid constitutional conflictInterpretive cannonTHE EARNED INCOME TAX CREDIT & REPROSE OF TAX EXPENDITURESCode: §32(a)-(c)(3), (i) (skim; you are not responsible for applying these sections either in class or on the examTextbook: 791-793Direct Expenditure (DE) v. Tax Expenditure (TE) (v. Regulation)how to evaluate tax policiesrevenue (cost)accountability (in the political realm) – Surry’s big critiquepolitical transparencybudget processsimplicityeasier through tax, but …code more complicatedinstitutional expertise/qualificationsupside down – Surry’s 2nd big critiquehigh income taxpayers get more value from same $ value deductionsfraud and error rateadvantages as appliedIRS is good at testing ATPNo cap on # individuals who can participate in EITCNo need for a new agency for EITC – administrative costs very lowA lot of waste (2B) to tax preparers b/c EITC is complicatedPolitical support for EITCGreater participation Is the EITC a tax expenditure?EITC = earned income tax credit §32We can think about EITC as an alternate or amendment to the tax rateRate changes don’t count as tax expenditures under our system (for IRS benefits)Is EITC a rate modification?If so, its probably not an expenditureIs EITC a wage subsidy for families?Is EITC an anti-poverty program?Maybe it is an expenditure b/c it has a social goalIs EITC an incentive to work?Probably an expenditureBitger’s argTax expenditures are in the eye of the beholderYou need a baseline of “normal” tax before you can determine what is an abnormal expenditureGov est. tax expenditures by using current law as the normal baselineDoesn’t really satisfy Bitger’s complaintDeviations from current law = tax expenditures Federal poverty measured by – 3x 1960s cost of nutritious diet, adjusted for inflationEITC(see 2 handouts)successfullargely due to its ties to work & separation from povertyless stigmatizing than welfare (TANF)conditioned upon work§32has phase outamount varies by kidwork for EITC = income for which you get taxedTANF (welfare) has a broader definition of workRefundable (unlike most credits) – 88% EITC refunded as cash payments Value to you doses not depend on your marginal tax rate (b/c it’s a credit)2015 EstimatesTotalRefundableEITC66.557.7CTC58.431.1has marriage penaltiesPhase-inPhase outMax creditA – Single, 2 kids1 – 13,87018,110-44,4545548B – married, 2 kids1 – 13, 87026, 630-49,9745548C – Single, 1 kid1 – 988018,110-39,13133592xC – twice row C1-19,76036,220-78,2626718if 2 single people, each with one kid got married, they’d move from 2xC to B and lose $people strategically earn to max out EITC (or at least that’s what’s self reported)high error rate for EITC but less expensive than welfare (welfare is more expensive but it has a lower error rate)so IRS has instituted a “pre-clearance” requirement for some taxpayersPROPERTY TRANSACTIONSTAX BASIS IN NONRECOGNITION TRANSACTIONSGIFTS, BEQUESTS, TRANSFERS BETWEEN SPOUSESCode: §§ 1001; 1011; 1012(a); 1014(a)-(c), (e); 1015(a), (e); 1041(a)-(c)Regs: §§ 1.1001-1(e); 1.1015-1(a); 1.1015-4(a)Textbook: 296-300; 784Problem: 21Problem 16 p300§1032 – like kind exchangespropertyrealization rule§1001 calculate gainG(L) = AR-ABGain (loss) = amount realized – Adjusted BasisBasis – after tax investment in the asset§1012basis = costcost = postbecause we can keep track of basis, we can defer tax and still tax on the right amountgifts & death are not recognition events – they don’t trigger taxation§1014(a)(1) – Basis of property transferred from a decedent = FMV at date of deathtax forgiveness – no tax on appreciation of assetthe “angel” of §1014§1015 – basis of property acquired by gift & transfers in trustdual basis ruledifferent rule depending if transferor has a built in gain or a built in lossFMV < basis = built in loss basis = FMV only if recipient will have a loss on recipient’s next transactionFMV > basis = built in gainRecipient gets transferors basisSee §1015 handout (flowchart)Gift = disinterested generosityEXAMPLEMarg (1)FMV = 90B = 80Built in gain = 10Gift to Steve B = 80B = 80 b/c Marg has a built in gain & §1015 says when transferor has a built in gain, the transferees basis is the transferors basis Marg (2)FMV = 90B = 100Built in loss = 100Gift to steveG(L) = AR – AB = 105-100 carryover basis = 5if AR = 90if you’re in the indeterminate range, the selling party has neither gain nor lossEXAMPLE 14 p298EXAMPLE p300Handout 4-9-15 examples Purpose of rule Shifting loss to someone in a higher bracketRealizationOccurs when you exchange something for something materially differentRecognitionWhen you have to occur in incomeUsually you have recognition when you have realization, though there are some statutory exceptions to this general policy §267prevents transfer or loss among related partiestransfers between spouses under §1041 are usually ignored for tax purposes but the gain is preserved by carryover basisProblem 20 p784Problem 21 p784Alimony is taxable as income to recipient and deductible by payer LIKE KIND EXCHANGESCode: 1031(a)-(d)Textbook: 275-282Regs: 1.1031(a)-1; 1.1031(d)-1(a)Problem: 22Like Kind Exchange – no recognition when:Exchange of Permissible property (t/b or inv)For like kind propertyThat will be held for t/b or inv§1031(a)(2)exceptions inventory can’t be a like kind exchange§1031(e) – livestock of different sexes aren’t like kind2 pieces of real property of any kind are exchangeable2 kinds of cars of any kind are exchangeable§1031(d) – how to calculate basis for exchangesEXAMPLEs (p282) – assume it qualifies under §1031 – what is the tax treatment?Marie – BlackacreFMV 500B = 200Marie’s G(L) = AR – ABG(L) = 500-200 = 300FMV whtieacre = Boot – Recognize gainsDon’t recognize losses§1031(c)recognize gain to the extent of the bootProblem 22CHARACTERTHE MECHANICS OF CAPTIAL GAINS AND LOSSESCode: §§ 1(h)(1)-(4); 62(a)(3); 1211(b); 1212(b)(1); 1221; 1222; 1244(a)-(c)(1), 267(a)Textbook: 889-901, 274-5Problem: 23Character of incomematters because ratessome kinds (long term capital gains) get favorable ratesreal limits on taking of capital lossesCapital losses can only offset capital gains and ordinary income up to 300K/yearWHAT IS A CAPITAL ASSETTextbook: 923-928Almost anything you own for personal or business use is a capital asset Long term capital gains (LTCG)(a) sale or exchange(b) of capital asset(c) held for more than one yearholdinghow long you’ve heldgift – transferors holding period and your holding periodtackingRates Marginal Tax RateLTCGDividends rate0-15%015%25, 28, 33, 35%15%39.6%20%+ Medicare surcharge3.8% not investment incomeTaxpayers want to characterize ordinary income to capital gains because it has favorable tax treatmentWhy do we have favorable treatment for LTCG?lock inincentivesriskcapital losses disallowed (limited)?Administrability Problem on netting capital gains and losses problem 1 p899You can only take your losses to the extent of your gains, but LTCG and STCG are taxed separately. Larger losses carry forward to the next year. 3K safety valve – 3K loss can be taken against ordinary incomePreference only on net capital gainCapital gain defined §1222§165 – statute for losses§165(c) – limited to losses(we generally disallow personal losses)you can take your losses to the extent of your gains but LTCG and STCG are taxed separatelylarger losses carry forward to the next year (still not great b/c TVM)3K safety valve – 3K loss can be taken against ordinary incomepreferential rate only applies to long term capital gainshighest tax bracket LTCG – 20%most taxpayers LTCG – 15%10-15% tax bracket LTCG – 0%problem 2 p900net long term capital gains aren’t netted with net short term capital gains §1222(a) – if they’re both gains – no netting capital asset defined §1221not inventorynot depreciable or real property used in t/b (gets better tax treatment)United States v. Maginnis (2004) (p923) (9th Cir)Family wins 23M in lottery. Split. Dad gets 9M – payable in 20 equal payments of 450K. Dad sells income stream in exchange for ~4M lump sum.Maginnis argues this is LTCG not ordinary income§1221 interpreted – substitutes for ordinary income will not be regarded as capital gainsholding – not treated as a capital gainthere has to be a real investment for there to be a capital gaincourt reads this in (not in the statute)§1221 is broadeverything is capital gain that’s not listedinterpreted narrowerif it’s a substitute for income, then its not a capital gain (Maginnis)net investment income taxdoes not only apply to capital gainscalled a Medicare surcharge – funds MedicareJan 2013 effectiveNot inflation adjustedIf AGI over – you get 3.8 tax in addition to whatever tax you payMarried, jointly 250K – AGISingles 200K – AGIInterestDividendsAnnuitiesSome capital gainsStock, bonds, mutual fundsReal estate (above §132 exclusion amount)Partnership s.corp interestNot wages, etc.Part of ACAQUASI-CAPITAL ASSETSCode: §1231(a)(1)-(3), (b)(1)SOME PREFERENCESREPRISE: CHARITABLE DONATIONs OF APPRECIATED PROPERTYCode: §170(e)Regs: 1.170A-1(c)(1)Text: 367-8 (review)Problem: Problem 9(f)charitable donation of appreciated propertydonor takes deduction to FMV without paying tax on gainAGI limit on amount of deduction §170 – AGI can be reduced by 50% unless its donation of appreciated property then it can be only reduced by 30%If you have a long term gain, the amount of deduction is its FMV problem 1 p380regs say amount of deduction is FMV of donated propertydon’t donate loss property – sell it and take your loss and then donate the proceeds PERMANENT EXCLUSION OF GAIN ON THE SALE OF A PRINCIPAL RESIDENCECode: 121Text: 288-9 (notes 5 and 6)Capital Gains Preferences§121 – exclusion of gain from sale of principal residencegain is excludable to extent of §121(b)250K individuals500K marriedprincipal residence = 2/5 years or moreREPRISE: LIMITATIONS ON PERSONAL LOSSSESCode: 165(c)Text: 306-308 (review)Problem: 24Loss Limits§165(b) loss limited to basis(c) loss limited to t/b, for profit transaction, casualty lossespersonal residence is not an investment property (regs) §1.165-9(a)if you sell house at a loss, you can’t take the loss unless you convert the house to a rental propertyother losses we’ve studiedcasualty losses allowed but subject to limits gambling losses only allowed to extent of gambling gainshobby expenses can be deducted up to gains §183hobby (activity not engaged in for profit) – see regs for what counts§469 losses from passive activitygenerally can be deducted only to the extent of passive incomeif you have net passive losses it is not allowed, but its carried forward indefinitely defined – involved conduct of t/b but you’re not materially participating rental activity is called out specially eg – rental activity (unless that’s your t/b)all rental activities are passive even if you materially participate (unless you are a realtor)§469(c)if you actively participate in management of rental property, you can deduct up to 25K if your AGI is below 150Klosses cant be taken against ordinary income except to extent of 3K a year §1211(b)CAPITALIZATION & COST RECOVERYCAPITALIZATION & DEDUCTIONCode: §§ 167(a)-(c); 168(a)-(e), (i)(1); 179; 197(a)-(d); 263(a); 263A(a), (b); 1016(a)(1)-(2)Regs: §§ 1.162-4; 1.179-1(f)(1); 1.263(a)-1(a); 1.263(a)-4(b)(1), (3), (c)(1), (f)(1)Textbook: 613-617; 619 (“Expensing under §179”); 620-622; 629-634; 651-653Packet: Rev. PRoc. 87-57, sec.s 8.01-.02Problem: 25Capitalize – add to capital account (i.e. Basis) … maybe depreciate/amortize over timeExpense – deduct full amount in year cost is incurred §162 business expenserepairfactorsold businessrecurringpreservation of status quo12 month rule§263 capital expenseimprovementbettermentrestorationcreation of separate assetfactorssubstantial future benon-recurringadds value§162 deductionordinarynot capitalnecessarybusiness, not personalordinaryprovide current benefitshouldn’t provide much benefit after this yearcapitalizationnot currently deductible in fullyou’re adding the cost to your basisyou may get to depreciate/amortize over timenot about capital assetsreason – matching principal Idaho Power case (we didn’t read)denial of deduction under §263 for capital costs takes precedence over §162 ordinary and necessary business expenseif your asset is a capital asset, you can’t expenseIndopco Inc. v. Commissioner (1992) (p629)Facts – friendly takeover of national starch by Unilever. They hire bankers & lawyers to make sure it’s a fair price (2.2M, 500K). National Starch deducts but IRS says they’re capital expensesNational starch argument – Lincoln Savings says capitalization requirement creating a separate and distinct asset (basis to which you’ll add)Court says – “separate and distinct” sufficient but not necessary for capitalizationIRS argument – they’re going to reap the benefits of this takeover for yearsBroad reading of Indopco – if the expenditure gives substantial future benefit then it should be capitalizedCourt – this is not deductible as ordinary and necessaryResult of Indopco = fear and uneaseIRS gives guidance to taxpayersRev Rul 92-80 (p633)Indopco did not effect treatment of ad. CostsGenerally don’t have to be capitalizedCosts associated with creation of capital asset (eg good will to build a power plaint)Good will with future benefit should be capitalized-4 and -5 regs – Indopco regs in 2004 to clarify let taxpayer expense some things that clearly have future benefittaxpayer favorable solutiondoes IRS have power to do this – controversy ?covers intangibleslist of intangibles that costs have to be capitalized$ to create intangible$ to buy intangibleif your expense is not listed you can expense (you don’t have to capitalize) even if they’re substantial future benefitIndopco regs seem to abandon Indopco and move to the Lincoln Savings “separate and distinct” ruleOn the narrow issue described in Indopco, IRS agrees with IndopcoFriendly takeover = capitalizeHostile takeover = expense12 month ruleif benefit <12mo, you can expense even if it reaches 2 tax yearsJob Hunting Expenses (p651)if you’re already in a t/b, you can deduct job hunting expenses within that t/bproblem 9 p653repairs v. capital expensesgoal – max expense with associated incomeMidland Empire PackingTaxpayer could deduct concrete basement when lining would prevent meat seepage because the seepage is newGoal – serving prior functionMore like a repair than an improvement because it helps you engage in old businessMt Morns Drive In Drainage system installed in response to threat of litigation by neighbor (3yr after building)CapitalizedIts not a repair when you just forget to do something n construction (rain and need for drain is foreseeable)2014 IRS put out new repair regs-3 and -4 under §163 regsretain facts and circumstances testcapital restore, add to value of assetmake like new; major replacementroutine maintenance is deductibleroutine = taxpayer expects to do it at least 2x over asset’s lifeif expense is <5,000 you can expense itIRS usually pretty generous to taxpayereg p637 rev rulmade as part of a general plan of modernization = capitalizationotherwise = expenseno bright line between repair and improvementdepreciation – see handouts it’s a capital expenseyou can’t always take deprecation deduction (eg not starch) but you want itnot a way to measure real economic declines in valueYEAR12345PV of Tax BenefitA) Expense10K00003500B) Capitalize, recover at end of life000010K3019C) Capitalize, recover ratably2K2K2K2K2K3206D) Capitalize, recover faster than ratably>2KBetween A) and C)^Conceptualize Options§167(a) – what is depreciable (not land – land gets no recovery until sale)Timingyou should figure life of assettry to match cost recovery to income generated by assetor allow taxpayer to recover costs faster than economic value in asset*What we do accelerate depreciation2 wayslower life of asset (then how it will actually last)increase rate at which you recoverbigger depreciation deduction in early years & lower in later yearsratably – straight linefast acceleration is often used as economic stimulustaxpayer wants shortest period, biggest deduction§167 authorizes depreciation deduction§168 mechanics for deductionAmortize intangible assets§197 – straight line amortization for certain acquired intangibles (eg goodwill) over 15 yearsTo figure depreciation deductionneed to know:basis - §1012salvage value (taxpayer says its 0) - §168(b)(4)method (how fast) §168(b)recovery perioduseful life §168(e) – shortens periodconvention – when taxpayer regarded as putting property into service - §168(d)(4)RECAPTURE OF DEPRECIATIONCode: 1245(a)(1)-(3), (b)(1)-(4), (d)Textbook: 618 (omit “Partial or complete expensing under §168(k)”)Problem: 26Principal Principal RepaymentInterest PaymentsCancellation of Debt (COD)BorrowerNot incomeNot deductibleDeduct if business (usually); non-deduct if personalIncome, unless §108 bankruptcy, insolvencyLenderNot deductibleNot incomeIncomeLoss (if it’s a bad debt, lender gets deductionDebtrecourse – other assets…personal liabilitynon-recourse – limited to security (you borrow & put up collateral for the lender. If you default, the lender gets the collateralif FMV < amount of debt, the borrower won’t pay & will default on the borrower because they’re not going to pay more than the asset is wornDepreciationyour way of recovering your basis over timeexception to realization requirement (we don’t make you sell to recover your basis)you don’t have to experience real economic loss (eg – even if an antique increases in value)recapture of depreciationif statutory depreciation exceeds economic loss, you’ll have againthat gain is includable ordinary income to the extent the gain is the result of the depreciation deduction§1245§1250TRANSACTIONS WTH BOROWED FUNDSCode: §§ 1001; 1012Regs: § 1.1001-2(a)-(b)Textbook: 157-167Packet: Crane v. Commissioner, 331 U.S. 1 (1974)Problem: 27Problem 27Crane v. IRS (1947) (packet)Facts – Crane inherited an apartment secured with a nonrecourse loan. She sold the apartment for $2500 cash & the buyer took the loan. She included as income $2500. Government argues her income is $2500 plus the amount of the debt she no longer had to payGovernment argues the basis is $262,000 (FMV at date of husband’s death)Crane argues basis is $0 (equity = property = economic benefit)But she had depreciated which is inconsistent with having no economic benefitShe basically says “oops, I shouldn’t have taken the depreciation deduction YearCrane’s ArgumentGovernment’s ArgumentTax Benefit Analysis1B = 0 “property” means equityB = 262,000§1014 FMV at his death262,0002-10(28,000)depreciation deduction (Crane says – should have been 0)(28,000) depreciation deduction(28,000)Year 10 ABB = 0B = 234,000You received an economic benefit234,000AR @ sale2,500 cash“property” means economic benefit262,000 assumption of debt + 2,500 cash = 264,5002,500Gain on saleG = AR – ABG = 2500 – 0G = 250030,5002,500 cash28,000 depreciation30,500*ignoring payment of interest so number maybe not matchholding – government winsCrane is taxpayer favorable rule because TVMReasoning – if someone pays off your debt its as good for you as if they gave you cash & you pay off your debtTaxpayer realizes a benefit in amount of mortgage & bootFootnote 37 – taxpayer will get boot if value of property > amount of debt^* issue in Tufts – mortgage > FMV of propertyPre-Crane – include non-recourse debt (NRD) (purchase money) in BasisCrane – on sale of property subject to NRD, include NRD in amount realized [at least to the FMV of the property][] footnote, not holdingThese rules resulted in tax shelter!everyone wanted to take losses to offset their personal services income gainstax shelters generate depreciation deduction to offset incomedepreciate nonrecourse debtCommissioner v. Tufts (1983) (p161)partnershipwhat happens to partnership happens to partners in proportion to their ownershipfacts partners got NRM 1.8M to buy apartment. Took deduction of 400K. In ’72 AB = 1.4MSold to Fred Bales for $250. FMV < 1.4MAmount of debt @ sale exceeds value of property – Crane fn 37 caseYearTufts ArgGov ArgTax Benefit AnalysisYR1 Basis1,900,0001.85M NRD50K cash1,900,000(agree)450,000not fishy450,000(agree)450KYR of sale AB1,450,0001,450,000 (agree)50KAR on sale1,450,000AR limited to FMV1,850,000amount of debt on propertyGain on SaleAR – ABAR – AB1.40 – 1.45 = LOSS (50K)G = AR – AB AB includes 50K cash1.85 – 1.45 = 400K400Gov wants 400K of depreciation back (they let taxpayer take 50K cash out first)Holding – when a taxpayer sells or disposes of property then he is required to include the outstanding amount of the obligation as an asset realizedCrane applies even when the NRM > FMV at date of sale Tax system takes nonrecourse debt as regular debtO’Connors argumentBifurcate into capital and ordinary incomeDep 450K – capital incomeEcon (50K) – ordinary cashTufts and Crane codified in regs §1001-2Purchaser (Fred Bales) Basis – no clear answer (depends on circuit)TAX SHELTERS AND LOSS LIMITATIONSCode: §§ 163(d); §469; 7701(o); 267(a)-(d); 269(a); 1211Textbook: 706-712, 739-743, 724-743 (time allowing)Packet: Estate of Franklin v. Commissioner, 544 F.2d 1045 (1976)Tax SheltersIdea – sell doctors/lawyers (people with lots of personal services income) guaranteed loss investments funded with a non-recourse loanEstate of Franklin v. IRS (packet)One of gov’s first big wins in a tax shelter caseFacts – Year 1 doctors put in 75K investmentDoctors “buy” motel for 1.224M with NRD (from original owners – Romneys)But original owns (who lent doctors $ to “buy”) still operateLeased back to RomneysRomneys get/have to do everything an owner would (eg mortgage property) – contract provides thisSale/leasebackDoctors pay 9K/mo interest butDoctors get 9K/mo in rentDoctors getInterest deductions offset rental income**depreciation deductions (on the basis of 1.224M)effectively the Romneys sell the doctors their 1.224M depreciation deduction for 75KGov here argues – Doctors paid way more than FMV that allowed them to take large depreciationsLower tax court says this was an “option to purchase” for the balloon paymentDoctors paid 75K for the option to buy the motel when the balloon payment was due (at the time it was due)There was never a sale – it was a shamTherefore you don’t get the tax consequences of a sale9th Cir says you can have a sale-leaseback like this; the problem is that this is not bona fide debt because the FMV is too lowif this is not bona fide debt, this should never have gave into doctors basis, and they should not have gotten the depreciation deductionsbecause these rules assume the doctors will pay back debt, and here they obviously won’t result doctors don’t get depreciation deductionmodifies Crane & Tufts – in order to be includable in basis for deduction, it has to be real debt (??)holding – doctors have 75K basis in motel – the debt is disrespectedthe debt generates no basis court does not respect debt up to FMV (the motel FMV was about 600K but court wont go there)Passive Activitieshow losses from passive activities can only offset gains from passive activities (not other ordinary income)§469if you’re a limited partner your gains/losses are passiveif you spend ≥ 500K a year its not passiveunused passive losses carried forwardpassive activity rules are overbroad but effective at ending tax sheltersdisclosure requirement – when you’re engaged in a tax shelterif you don’t disclose you pay a penalty – no statute of limitations on thisaccuracy penaltiesmaterial advisors must closeeconomic substance §7701(o)objective & subjective prongsadded to pay for the affordable care act (?) even though it purports to codify pre-existing lawconjunctive rules – must have both objective & subjective prongto seek accuracy provision under §7701 IRS needs higher up approvalnot intended to make taxpayer pay penalties every timeobjective prongforeign taxes are regarded as costs for determining objective prong (changing taxpayer economic position) ................
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