Beruflich Dokumente
Kultur Dokumente
(Fall 2013 / Textbook: Bankman, Federal Income Taxation, 16th ed. 2012)
Introduction: Setting the Table
Tax Policy
Civilized society laws government(s) taxes (through either government spending or tax
breaks)
Size and structure of government is center of policy debate
Who gets taxed (people, corporations)
7/8 of tax revenue comes from individuals
1/8 of tax revenue comes from corporations
How much we tax
Consult table on p. 3 to see where federal revenue comes from
Tax base: thing that is taxed (income, property, sales, estates, consumption, wealth)
Tax Fraud
Tax gap = difference between the amount of taxes we would collect if people complied
perfectly with tax law and the amount of tax revenue generated in reality
Who is cheating on their taxes? Overall, US has high level of tax compliance.
Average person doesnt cheat. Employers have an incentive to accurately report how
much money you are getting paid because thats a deductible expense to them. That
means there is no much opportunity for individual to cheat.
Roughly half of the tax cheating comes from small businesses and self-employed people.
Particularly among cash businesses. Its a problem that arises from norm and opportunity,
not complexity of the tax code.
Large business dont cheat that much. Large businesses, by definition, have lots of people.
When you have lots of people in a business you have to keep track of cheating among
your employees. Largest businesses are under permanent audit. So it turns out tax gap is
not due to larger businesses.
Tax Incidence
Incidence of tax = who is really bearing the burden of the tax; who ends up with less money
in the bank as a result of it
Corporate income tax is collected from corporations, but the incidence of the tax is on
employees, shareholders, and suppliers
Tax expenditures vs. tax cuts
The same goal can be accomplished whether through tax expenditures or tax cuts
But politicians of course prefer to call something a tax cut than expenditure increase
Table 1-2: Housing ownership subsidies, pension subsidies & healthcare subsidies are the
largest tax expenditures
Tax Law -- Sources
Internal Revenue Code of 1986 (Title 26 of the US Code)
Note that whenever the Code says to the extent, that can be read as by the amount
Civil law
Goal is to try to make taxpayer and the Treasury whole
So tax evader will have to make up for underpayment as well as interest
Penalties may also be imposed, but that depends on how severe the evasion was
Criminal law
Criminal penalties rarely applied
Only apply where heightened mens rea is found (purposefulness w/o a reasonable belief that
what you are doing might be legal)
Treasury Regulations
Interpretive guidance
Fill in gaps in the Code
Not updated reliably
Revenue Rulings
Look and read like opinions, without the names of the taxpayers
Treasury can issue advisory opinions (unlike courts)
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Tax Litigation
Very few tax controversies get litigated
Why? There are many opportunities to resolve the dispute before trial: letters, internal hearings,
offer-and-compromise process (where taxpayer gets to make an offer and IRS will consider and
maybe accept it)
Litigation forums:
COFC
Federal Circuit
SCOTUS
Federal
district court
Circuit court of
appeals
Taxcourt
Taxable income
Marginal tax rate = tax percentage paid on the next/last dollar of income
Next/last not the same thing, but often turns out to be the same thing
Zero bracket (ZB) = amount of income on which a taxpayer pays no income tax
It is possible to have a positive income and yet pay no income tax at the federal level b/c of
this zero bracket
Progressive rate
Rate rises as income rises
Federal tax system is designed to be progressive on its marginal rate and average tax rate
Regressive rate
Rate falls as income rises
Proportional rate
Rate is constant as income rises
Example: social security tax is proportional up to a certain threshold
Code 1 contains list of tax imposed depending on income
How to determine taxable income:
Taxable income = gross income zero bracket
Zero bracket = standard deduction + personal exemptions
Standard deduction = amount everyone is allowed to deduct (p 646 in textbook)
Personal exemptions = $3800
In a graduated bracket system (progressive marginal rates), you get an average rate that is
always lower than your marginal rate (unless its zero)
Example of calculating income tax:
Family of four. $420k in income.
Taxable income = $420k - $27,100 = $392,900
Tax owed = $105,062 + 0.35($392,900 $388,350) = $106,654.50
Average tax rate = $106,654.50 / $420,000 = 25.4%
Marginal tax rate = 35%
What is Income?
Some Characteristics of Income
Income is a flow variable
Flow variable can only be defined relative to the passage of time (e.g. $/year)
Wealth is a stock variable
Stock variable defined at a moment in time
Haig-Simons Definition
Y = fmvC + NW = consumption + savings
fmvC = fair market value of consumption
NW = change in net worth = change in persons property rights
Note that savings can be negative
The Code starts with the Haig-Simons definition of income, and then Congress whittles it down
Problems with applying Haig-Simons definition in real life:
Realization vs. accrual
An asset can grow in value, which increases individuals net wealth, but you dont
necessarily realize that growth in value (by turning it into cash), so taxpayer doesnt
necessarily have a greater ability to pay the tax.
In the real world, we use realization system. Taxpayer only gets taxed when he turns asset
into cash. Taxpayer can grow really wealthy but not have to pay tax on any of it (e.g. if he
holds stocks that grow tremendously in value).
Imputed income
Income through non-market transactions, e.g. enjoyment, growing your own vegetables,
cleaning your own home, stuff you do by yourself or stuff that has only a value to you
Example: You own your house fee simple. When you dont have to rent, that means you
dont have to pay rent money. So its rent-free living. Haig-Simons would say fair market
value of consumption how much would it have cost to rent your house in a fair market
transaction? So the proper definition of income would include imputed income from
owning a house.
Below market sales
People dont pay fair market value for everything. So income would be overstated when
taking into consideration those goods/services for which people paid below market prices
(e.g. in-state tuition).
Taxing leisure
Leisure time could be counted as income, and would be valued at its opportunity cost.
Valuation problems.
It can be hard to determine fair market value (what someone would pay in arms length
transaction) sometimes
Treasury Reg. 1.61-1: tells you what Code 1.61 says
Treasury Reg. 1.61-2(d): tells you how to value something in $ that was paid for not in $
If services were paid for with property use FMV of property
If services were paid for by some other means tax payer is allowed to estimate the
value of the services, and is given the benefit of the doubt with regard to that
estimation
Three sub silentio exceptions to income included under Haig-Simons/Code 61 (other exclusions
are explicitly written into the Code):
Imputed income doesnt get taxed
Some below market sales dont get taxed (e.g. in-state tuition)
Leisure
Policy goals in defining income:
Horizontal equity: Treat likes alike. If you have two people who are in other ways similar but
they receive their income in different forms, then we want to treat them the same.
Vertical equity: Those who have greater ability to pay should be taxed more than those who
have lesser ability to pay.
Old Colony Trust Co. v. Commissioner (US 1929)
Things that dont necessarily look like income are counted as income
5
Income tax paid by employer directly to the IRS constitutes employees taxable
income
Facts: Employer paid the employees income taxes for the employee. IRS says that paying
of the income tax is itself income.
Held: This is equivalent to the taxpayer having received the money directly from the
employer and then using that money to pay the taxes. Simply because it came in a
different form doesnt change the substance.
Grossing up
Employer can pay employee more to compensate the employee for the income taxes that he
will ultimately have to pay
To determine how much gross income an employer will have to give an employee to make
sure that employee receives the agreed upon amount, use the following calculation:
G = N/(1-t)
Gross income = income before taxes
N = net pay = desired amount negotiated between employer/employee
t = tax rate
Example
Employee/employer agree that employee should ultimately get $80k/year. Tax rate is 20%.
How much should employer pay employee?
G = N/(1-t) = 80k/(1-0.2) = 80k/0.8 = $100k
Grossing up in the instance where grossing up would put employee in a new tax bracket
Example:
Lets say the boundary b/w the 20% and 25% tax bracket is $50,000.
Employee wants his net pay to be $48,000. G = 48k/(1-0.2) = $60k.
But once you gross up to $60k you are in the 25% bracket.
So then you do G = 48k/(1-0.25) = $64k.
Gross income should be somewhere in the range b/w $60k and $64k. You would need
Excel to get the precise answer.
Noncash Benefits
Code 161 specifically mentions fringe benefits that are to be included in income
Why do we tax noncash benefits?
Noncash benefits are included in income to promote horizontal equity. If employer pays one
employee $100k in cash and another employee in benefits worth $100k, then employees
should be treated the same.
Employers would be incentivized to pay their employees through noncash means
When noncash benefits are NOT included as income
Common law
When lodging and meals are provided for the convenience of the employer, they are not
considered income. The convenience of the employer test is not just for camps provided
by employers. Benaglia.
Burden of proof is on the taxpayer to prove that the meals/lodging were for the
convenience of the employer
Court in Benaglia turns positive, statutory law in a Reg into common law
Benaglia v. Commissioner (BTA 1937)
Facts: Husband and wife filed joint tax returns in 1933 and 1934. The husband works
as manager of two hotels and a golf club in Hawaii. Husband and wife are provided
lodging and meals at one of the hotels at which the husband is the manager. Husband
reported salary he received on his tax return but did not include the value of the
lodging and the meals. The Tax Commissioner served deficiency notice.
Held: Because the lodging and meals were provided for the convenience of the
employer, they need not be included as taxable income. Its convenient for his
employer to have Benaglia live and eat at the hotel because Benaglia needs to be
constantly available to respond to client requests.
Dissent:
Dissent argues that convenience of the employer test is faulty. It creates
horizontal inequity, by not treating likes alike.
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Even if we do apply the convenience of the employer test, meals/lodging here were
not provided for the convenience of the employer. Benaglia didnt live at all the
hotels he was managing and he took extended vacations away from the hotels/golf
club.
Valuation under Benaglia
If Benaglias had lost and were required to report the lodging/meals as income, how
should they value the lodging/meals?
It should be the fair market value of what they received (would require further
factual findings)
To calculate fmv, you would ask: how much would a horizontally equivalent person
have to pay in the same situation? The difficult thing is that there might not be any
such people.
Code 119 (p 119)
Meals and lodging can be excluded from gross income but only if . . .
In the case of meals, meals are furnished on the business premises
In the case of lodging, the employee is required to accept such lodging as a condition
of his employment
To determine if employee was required to accept lodging, court can look to
employment contract but doesnt necessarily have to believe what it says
119(b)(4) non-discrimination requirement
If you have a group of employees, and they get free meals on the business premises of
the employer, and you have determined that half of them or more are getting them for
the convenience of the employer, then the others get a free ride
119(d) exception (meaning value of the lodging DOES have to be included as income) for
those cases where lodging is furnished by an educational institution and the rent is
inadequate
Numerical example.
Appraised value of lodging = $300,000
Rent paid by the employee = $250/month = $3000/year
Rent paid by non-employees = $1000/month = $12,000/year
Section 119(d)(2): exclusion does not apply . . .
119(d)(2)(A): to the lesser of . . .
119(d)(2)(A)(i): 0.05*300000 = $15,000
119(d)(2)(A)(ii): $12,000
OVER
119(d)(2)(B): $3000
So you do have to include as income $12,000 - $3,000 = $9,000
Code 132 -- Fringe benefits that should not be included in gross income (even though they
technically fit under the Haig-Simons income definition)
Rules of general applicability to fringe benefits:
132(h) retired and disabled employees and surviving spouse of employee who died
while employed by employer is treated as employee
Non-discrimination rule ( 132(j)) Company can provide non-taxable fringe benefits
but only so long as it does so for pretty much every employee in the company and
doesnt just aim it at highly compensated executives
(1) No additional cost service
Situation where the employer is providing a service and providing it to the employees
doesnt cost the employer anything
Line of business requirement if employee doesnt work in the line of business from
which he is getting the benefit, then value of that benefit must be counted as income
Examples:
Usher at movie theater watches a movie that is already being shown for customers
Airline employees given empty seats on a flight
(2) Qualified employee discount, 132(c)
Employer can sell the employees goods at cost, but not for an actual loss
Line of business requirement if employee doesnt work in the line of business from
which he is getting the benefit, then value of that benefit must be counted as income
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Example: employee works for Proctor and Gamble. If P&G charges customers $5/quart
for Tide, but makes a $1 on each sale, then employee needs to only pay $4 and
doesnt have to include that extra $1 as income. However, if P&G only made 25 cents
for each $5 quart sold, and sold it to employee for $4, then employee would have to
include 75 cents as taxable income.
(3) Working condition fringe
Anything the employer could deduct from their taxes, the employee could deduct also
by not paying tax on that
Example:
Employer buys book that is relevant to the companys line of work. If employee
bought the book, that should not be included as income.
Employer gives employee money to buy something that, if the employer had
bought it himself, would have been able to be deducted from taxable income
(4) De minimis fringe, 132(e)
Something really small in value
No line of business requirement
Example:
If employee is provided with coffee and donuts at a work meeting, he need not
count it as income
If employer puts out a bowl of candy for employees to share, employee need not
count a piece of candy as income
NOT meals provided to airline employees on flights (though those qualify under
convenience of the employer exclusion)
(5) Qualified transportation fringe, 132(f)
Transportation stuff
There is a limit however to the amount of service that can be excluded
Example:
IRS Commissioner gets driven around in limousine. Does he have to include the
value? Yes. Limousine is not a commuter highway vehicle. Those are really only
shuttle vans running between remote employee parking lot and office building.
How much should the Commissioner include? Reg. 1.61-21 says to include the fair
market value. Reg. provides a safe harbor provision; fair market value can be
estimated as the amount paid by the employer to the employee. Even if thats
wrong, you wont get in trouble.
(6) Qualified moving expense reimbursement
If employer gives you money to help you move for job purposes, then it doesnt count
as income
Section 217 defines moving expenses
(7) Qualified retirement planning services
If employer plans 401(k) planning service fees to manage retirement fund, then you
dont have to count what employer has paid as employees income
Example:
If employer hosts a JP Morgan representative to talk about retirement planning
services, employee doesnt have to count that as income
Cafeteria Plans (Code 125)
Benefits that employer can make available to employees that are deductible from taxable
income
But if other employees dont want those benefits, they can take cash instead (which is
taxable)
Cafeteria plan benefits include things like group term life insurance, adoption assistance,
excludable accident insurance
Regulations and safe harbor provision relevant to chauffeur services, Reg. 1.61-21(b)(5)
The FMV of chauffeur services provided to the employee by the employer is the amount that an
individual would have to pay in an arms-length transaction to obtain comparable chauffeur
services
Safe harbor = FMV of the chauffeur services may be determined by reference to the
compensation received by the chauffeur from the employer
Gain = $1200 -- $1000 = $200 because this number is positive, we must use original
purchase price
Gain = $1200 - $1500 = - $300 this is not right either because we end up with a loss.
So in this scenario, taxpayer declares no gain or loss. Taxpayer just reports $0.
Transfers at Death
Section 1014(a) taxing sale of property by heir that was passed to him/her by will or intestacy
When property is transferred at death, and then relative turns around and sells the property,
the basis is the value of the property on the date of death
Creates a lock in effect -- The older you are, and the more the property has appreciated, the
less likely it is that you will want to sell the property. You have a very good incentive to take
advantage of 1014(a)(1) for your heirs.
What an old person would prefer to do instead is to borrow against the shares loans are not
countable as income
Estate tax
You can give a total of $5.25m throughout life and at death without getting taxed
Only when the transfers amount to more than $5.25m does the estate have to pay a tax
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Loans
Income to borrower
Loans do not count as income
Discharge of indebtedness does count as income
Borrower cannot deduct interest payments when
borrower is a corporation
Borrow can deduct interest payments when borrower
is an individual (only applies to specific types of
loans)
Income to lender
Repayment of principal does not count as income to
lender
Interest payments do count as income
Debt-equity distinction
Equity: ownership interest, where Party A gives money to be invested in a business enterprise,
in return for some of the profits; owning stock is a form of equity
Debt: loan from Party B to Party C where Party C agrees to pay specific amounts at specific
times
Company has to pay back loans before it pays shareholders
Bond is a type of loan, buyer of bond is lender and seller of bond is borrower
Structuring loans to make them less risky to lender:
Secured v. unsecured loans
Recourse v. non-recourse loans
Recourse loan: borrower is personally on the hook for what borrower said he would pay
Kirby Lumber plain vanilla DOI case
Discharge of indebtedness income is counted as taxable income.
Facts: Kirby Lumber decides that they need to raise money. They issue their own bonds worth
$12m in July 1923. Then Kirby Lumber re-purchases $1m in bonds for $862,000. So they
increased their net worth by $138,000.
Held: the $138,000 is taxable. There was a clearly realized accession to wealth. Accession was
realized in the year the debt was discharged.
Kerbaugh-Empire reference Court uses KE case to distinguish. But the problem is that KE isnt a
DOI income case at all. They borrowed 1 million reichsmarks and paid back 1 million reichsmarks.
Application of Kirby Lumber
When custodial parent gives up on trying to recover child support payments from noncustodial parent who refuses to pay, the deadbeat parent has DOI income.
The rationale is that wed at least rather have tax on DOI income than no child support
payments at all.
Code s 108
Exceptions categories of people who dont have to recognize DOI income as taxable income:
108(a)(1)A). When a taxpayer is declared bankrupt, any DOI income he has is not taxable.
108(a)(1)(B). When a taxpayer is insolvent, any DOI income he has is not taxable.
Definition of insolvent. 108(d).
When liabilities > assets. When net worth is negative.
Rationale = dont hit a person when hes down
108(a)(1)(C). Discharge occurs when indebtedness is qualified farm indebtedness.
Qualified farm indebtedness is defined in 108(g).
Qualified farm indebtedness = debt incurred in the operation of a farm by a person
who, during the three preceding taxable years, derived more than 50% of his or her
annual gross receipts from farming
Farmers dont have to be insolvent to get the exception. Congress loves farmers.
108(a)(1)(E). Discharge occurs when qualified principal residence indebtedness is discharged
before January 1, 2013.
So basically this helps people who were kicked out of their home during the recession.
Its not that helpful because people whos principal residence indebtedness is discharged
are also highly likely to be insolvent, so they wouldnt have to count DOI income under
108(a)(1)(B).
108(h) defines principal residence indebtedness.
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If you have loss on sale of home, you are not allowed to deduct that loss.
121 excludes gain on sale of home from taxable income
A single taxpayer gets to exclude $250k or less
A married couple gets to exclude $500k or less
Any amount of gain over and above the exclusion limit is taxed at a capital gains rate
If a taxpayer doesnt qualify for the exclusion because of the use, ownership, or timing
requirements, the taxpayer can still exclude some of the gain if the reason he or she is selling the
house is because of:
Change in place of employment
Health
Unforeseen circumstances
Examples:
Blended family moves to childrens school district
Adult child moves in with parents
Taxpayer adopted kids and wants to get bigger house
Disabled parent moves in with taxpayer and taxpayer must buy different house as a
result
Aircraft noise
Child assault on school bus, so family moves to new school district
DEA (narcotics) agent threatened by drug lord and has to move
How much can taxpayer exclude if he doesnt qualify for the full exclusion but falls into one of the
special categories (health, change in place of employment, unforeseen circumstances)?
(no. of months since TP used exclusion/24 months)*(total amount of exclusion for which TP
would normally be eligible) = $ amount
Example:
Wife lived in House A from 2009 to 2010. Husband lived in House B from 2009 to 2012. Wife
lived in House B from 2010 to 2012. Wife sells House A on July 1, 2011 for $450k gain and
uses the exclusion to exclude $250k from taxable income. Husband gets sick and Husband
and Wife sell House B on January 1, 2013 for $500k gain. How much can they exclude?
Answer:
Husband gets $250k exclusion because he has not used the exclusion in the past two years,
and he owned and lived in the home for the past three years.
Wife used the exclusion 18 months ago when she sold House A, so she gets to exclude
(250,000)*(18/24) = $187,500.
Together they can exclude $250,000 + $187,500 = $437,500. The remainder of the gain
($62,500) is taxed at capital gains rate.
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Section 111 (the tax benefit rule), which is limited to situation where TP got literally no
tax benefit in the earlier year
18
19
20
-- $80k = $20k.
So 2012 income can be reduced by $20k.
1341(b)
If you embezzle money, you have to pay taxe
on that income.
However, if its found out that you embezzled
and have to pay the money back, you cant
take advantage of 1341 or 172 (NOLs)
Eisner v. Macomber (US 1920) for income to be taxable, the income must be realized.
Stock dividends are not realized gain to taxpayer.
Buchanan says that the governments arguments are right given the law at the time. The
Supreme Court gets it wrong here.
Facts: Macomber is a stockholder. She owns 2200 shares of stock in Standard Oil. In 1916,
company issues stock dividends. So Macomber receives an additional 1100 shares. She now has
a total of 3300 shares. Because par value of the stock is $100/share, it looks like she has received
income of $110,000, but the market value of the total number of stocks she owns has remained
the same. IRS argues the stock dividend was income and the issuance constitutes a realization
event.
Held: the issuance of the stock dividend was not a realization event.
Governments arguments:
(1) stock dividend is income. The law at the time explicitly said that a stock dividend is
income. Court says the statute is unconstitutional and that a stock dividend is not income.
While its true that a stock dividend is not income, the way the court got to that conclusion
made a big mess.
(2) issuance of stock dividends is a realization event. Buchanan thinks Brandeis dissent
got it right: substance dominates form. Giving Macomber the stock dividend would be the
same as her selling her shares back to Standard Oil, the company giving her money, and
then she buys the shares herself. In that scenario, the purchase of the stocks would be
counted as income, so the equivalent should be counted as income.
(3) the time at which the stock dividends are issued is no worse a time than any other
time to tax the income. Macomber had been getting a free ride for years, so that should
come to an end.
Aftermath of Macomber
Congress put realization requirement into section 1001 of the Tax Code
Exactly as Macomber is saying, when you have a disposition of property, any excess that is
realized will be counted as realized and any loss that is realized will be counted as a loss
Bruun v. Helvering (US 1940)
Realization events are not limited to cash exchanges.
Gain may occur as a result of (1) exchange of property, (2) payment of the taxpayers
indebtedness, (3) relief from a liability, or (4) other profit realized from the completion of
a transaction
Court limits Macomber severability and detachable language so that it only applies
to stock dividends. Bruun narrows Macomber.
Facts: Bruun leases building in 1959 with a 99 year lease. In 1929 lessor builds a new structure on
the property that increases the value of the property $50k. In 1933, lessor defaults on the lease
payments and the property gets return to Bruun. IRS says Bruun has realized income in the year
1933 in the amount of $50k because of the improvements on his property.
Held: this was a realization event, so Bruun recognized income in 1933.
Court limits the Macomber opinion to its facts. In Macomber the court seemed to say that for
realization event to occur, the income must be severable or detachable. The court says
that requirement only applies to stock dividends.
Bruun Aftermath
Section 109 = future Bruuns do not have realization events. Where a lessee makes improvements
(some kind of structure or something attached to the land) upon a property and then defaults on
the payments with the result that the more-valuable property goes back to the lessor, the lessor
does NOT have to recognize income.
Stock dividends are still not income.
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Section 1019 = if/when lessor sells the improved property, the basis is the value of the old
land/building, not the value of the land/building with improvements. The IRS wants to tax every
dollar of gain that the lessor got.
Whether you apply Bruun framework of 109/1019 framework, the ultimate amount subject to
income tax is the same:
In 1933, lessor gets property back with $50k in improvements. Hes able to rent the property out at
$7k per year.
Bruun
$50k realization event in 1933
$7k income per year for 10 years but with
depreciation deduction each year of $5k (so $20k in
income over the course of ten years)
Total income of $70k
109/1019
No realization event in 1933
$7k income per year for 10 years ($70k total in rent
income)
Total income of $70k
Note 3, p 211
Reg. 1.61-8(c) says that if building is basically a substitute for rent (determined by the facts and
circumstances), then the building will be counted as income
If IRS thinks this is happening, then IRS would determine what the rental rate would be for a
property like this, and then charge it as income to the taxpayer.
Woodsam
There are some transactions that are not realization events. Change from recourse to
nonrecourse mortgage is one of them.
For a sale or disposition of property to count as a realization event, someone has to give
up ownership of something; there must be a relinquishment
The borrowings did not change the basis of the property for the computation of gain or
loss
Facts:
In 1922, Mrs. Wood bought a piece of property for $296,400
Mrs. Wood was personally liable for the mortgage she owed on that property (recourse
mortgage liability)
In 1931, she re-mortgaged and consolidated the mortgages into a $400k nonrecourse
mortgage meaning she was not personally liable for the mortgage
In 1933, she defaults on the loan. The mortgage lender takes possession of the property and
cancels the mortgage. The mortgage balance by that point was $381,000.
IRS argues that Wood should have to recognize DOI income in the amount of the loan
cancelled.
Wood argues that she should have been taxed when the loan was converted from a recourse
to a nonrecourse mortgage because that was tantamount to a disposition of the property
since legal entitlement to the property was transferred to the bank should she default. So in
1931, she should have been taxed on more than $100k gain, but SOL has run to tax that
income. Because IRS didnt tax at that point, basis became $400k and her corporation
suffered $19,000 loss when the property was sold for $381,000.
Held: Change in the type of loan from recourse to nonrecourse is not a realization event. There
was no relinquishment of the property after the 1931 refinancing event.
Savings and Loans Crisis
S&L companies were depository institutions for the personal side of banking
Individuals would deposit their money into S&Ls and take mortgages out of S&Ls
The way the S&Ls would make money would be to charge a higher percentage rate on the
mortgages they loaned out than the percentage rate that the S&L paid out on deposits
The S&L balance sheet looked like this:
Assets
Cash
Mortgages issued (issued at 7% interest
rate)
Liabilities
Deposits (generating 5% interest/yr)
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IRS test for material difference: look to the attitudes of the parties, how the market treats
the property, the views of the relevant regulatory agency. Court thinks this test is too
subjective and un-workable. Buchanan thinks the test is workable in these circumstsances.
Courts test is whether the respective possessors enjoy legal entitlements that are
different in kind or extent by virtue of the exchange.
Court says that if you adopted IRS position that there can only be a meaningful
difference if theyre different in a way that an investor would care about then that would
render the like-kind doctrine unnecessary.
o Buchanans two responses:
Thats wrong. If you think about what LKE doctrine encompasses, LKE would
clearly expand what the IRS is trying to get at here.
It is an example of where the court is reading into the Tax Code a
requirement that there not be surplusage. We know thats not true in the
Tax Code; the Tax Code is very repetitive.
o The court gives no reason as to why the word material doesnt mean anything in
the phrase material difference
Cottage Savings makes the second scenario look different, and because of that we waste
economic resources (someone has to segregate the cotton).
Problem 2, page 226.
Machorari cars. Get sent to dealers. Dealers customize the cars for their ultimate clients. Susan is
in New York City and she owns Streaker #13. Josh is in Miami and he owns Streaker #14. Upon
delivery, Susan gets #14 and Josh gets #13 by accident.
Each have a basis of $500k because thats who much they paid upon delivery. The FMV of the
cars is $750k.
If they ship each other the cars
No realization event
To avoid recognizing gains, Josh and Susan will have to do the more expensive thing!
Non-recognition and like-kind exchanges
Non-recognition rules are those where you have realized gains but Congress says you dont have
to recognize them until later
Theyre transfers of property that should be income and should be realized, but Congress says
theyre not
Rationale behind non-recognition rules:
Gain should not be recognized if the transaction does not generate cash with which to pay the
tax
Gain or loss should not be recognized if the transaction is one in which the gain or loss is or
might be difficult to measure valuable problems
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Gain or loss should not be recognized if the nature of the taxpayers investment does not
significantly change (as long as TP is doing the same type of business as he was before the
exchange, gain or loss shouldnt be recognized)
Gain should not be recognized in order to avoid discouraging mobility of capital
Like-kind exchanges are the most prominent kind of non-recognition events
Like-kind exchanges
Original purpose = allow farmers to trade farm lands
Section 1013: if you have two businesses that have similar types of property (held for
productive use in a trade or business or for investment) and they want to exchange them,
thats a realization event but it doesnt have to be recognized for tax purposes in the year of
the exchange
Exceptions!! (times when similar property is exchanged and the gain/loss DOES have to be
recognized; excepting out property thats not real property):
Exchange of:
Stock in trade or other property held primarily for sale (inventory)
Stocks, bonds, or notes
Other securities or evidences of indebtedness or interest
Interests in a partnership
Examples are these exchanges taxable? Page 229
Stock for stock falls within exception, so exchange is taxable.
Farm held for investment for another farm not taxable, so long as the second farm was
also held for productive use or for investment.
TP sells farm, gets cash, uses cash to buy another farm taxable, this is a normal
purchase not a like kind exchange.
Farm for fleet of tractors taxable, not a like-kind exchange.
Boot
Boot = cash and non-like-kind property
Recognizing gain/loss in the year of the transaction
NO BOOT
You dont have to recognize a gain or loss in the year of the transaction, except under certain
circumstances:
Stock in trade or other property held primarily for sale (inventory)
Stocks, bonds, or notes
Other securities or evidences of indebtedness or interest
Interests in a partnership
THERE IS BOOT
TP gains from the exchange (fmv of what TP got > basis in property TP gave away), then the
amount of gain TP must recognize is lesser of the amount of gain realized or the amount of
the boot. 1031(b).
TP loses from the exchange (fmv of what TP got < basis in property TP gave away), then TP
reports $0.
Since most of the time you want to recognize losses, youd be better off selling the
property for a loss than exchanging the property for a loss.
Example 1. Example of 1031(b) where gain > boot.
TP gives up property with basis of $10k. In exchange, she gets property with fmv of $100k,
cash of $15k, and tractor worth $8k.
Boot = $15k + $8k = $23k.
Proceeds from sale are $123k.
Her gain is $123k - $10k = $113k.
She only has to recognize the lesser of the amount of the gain ($113k) or the amount of the
boot ($23k). So her recognized gain is going to be $23k.
Example 2. Example of 1031(b) where gain < boot.
TP gives up property with basis of $110k. In exchange, she gets property with fmv of $100k,
cash of $15k, and tractor worth $8k.
Boot = $23k.
Proceeds from sale = $123k.
Gain = $123k - $110k = $13k.
She has to recognize gain of $13k.
Example 3. Example of 1031(c).
TP gives up property with basis of $130k. In exchange, she gets property with fmv of $100k,
cash of $15k, and tractor worth $8k.
Boot = $23k.
Proceeds from sale = 100k + 15k +8k = $123k.
Loss from sale = $7k.
So she has $0 in gain/loss to report.
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Basis
So when you ultimately go to sell the property you just got in the exchange what should you use
as your basis?
When theres no boot at all the basis for the property received will be the same as the basis of
the property relinquished
When there is boot
(A + B) D = E = substituted basis of the like-kind property received
A = original basis of the property you just traded away
B = amount of gain recognized = tax consequence today
Gain realized = proceeds basis in property traded away
If positive use that number for gain recognized
If negative use 0 for gain recognized
D = fair market value of the boot (this is positive if you got boot or negative if you gave it
away)
Example 1 (gain to TP from transaction):
TP has basis in farm X of $10,000. She trades for farm Y, which has fmv of $100k, and boot of
$15k. Original owner of Y farm has basis of $50k.
So that means farm X must have fmv of $115k.
How much should TP getting farm Y recognize in gain
in the year of the transaction?
29
Result for W?
30
$250k
Result for H?
Punch line.
Note: 1041 applies only to couples that are married as recognized by federal law (so same-sex
couples dont get 1041 treatment).
Alimony
Alimony
Alimony counts as income to the recipient. 71.
Payor gets deduction for the amount of the alimony payment. 215.
To be properly considered alimony, the payments must meet certain conditions:
(1) Payment must be in cash. 71(b)(1).
(2) Payment must be received under an instrument of divorce or separate maintenance.
Oral agreements will not do.
(3) The payments have to be taxable to the payee and deductible to the payor.
Parties can opt out. Can elect not to include in income and not to deduct.
(4) The parties must not be members of the same household.
(5) The payments cannot continue after the death of the payee spouse.
If payment made is less than the full alimony + child support payment the payor was supposed to
make, then the payment should be treated as child support first and then the balance is to be
treated as alimony. 71(c)(3).
Example: Payment is supposed to be $2000. Thats $1200 in child support and $800 in
alimony. Payor only pays $1500. So $1200 is treated as child support and $300 is treated as
alimony.
Child Support
Child support does not count as income to the recipient
Child support payments are not deductible to the payor spouse. Its just a personal expense,
which is not deductible. 262.
Excess Front-Loading
Scenario: Payor is paying a lot of money to payee incident to divorce. Its being called alimony,
but it should be property settlement.
Section 71 (p 73 supplement)
Section 71(f)(4): Excess payments for second post-separation year
71(f)(4) = A B
71(f)(4)(A) = alimony payments made in second year
71(f)(4)(B) = alimony payments made in third year + $15,000
Section 71(f)(1)
The payor spouse includes the excess payments in his gross income in the third postseparation year
The payee spouse deducts the excess payments from her income in the third postseparation year
Example: $50k in year 1; $0k in year 2; $0k in year 3
Excess payments for second post-separation year
71(f)(4) = $0, there is no excess.
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33
Diez-Arguelles v. Commissioner (Tax Court 1984) Wife cannot deduct non-paid child
support payments. Lack of child support payments does not fall under section 166. In
order to write off the money that you are owed, you have to have some kind of basis/cost
that you paid to get that in the first place (example = you incur costs in producing
iPhone. Customer never pays. You can deduct that as nonbusiness bad debt.)
Facts: Deadbeat dad. Kevin doesnt pay child support. Christina tries to deduct what she should
have gotten as a nonbusiness bad debt under section 166. IRS disallows this.
Held: Christina cant deduct what she didnt get as a nonbusiness bad debt. Buchanan thinks Tax
Court got it wrong.
(1) Court looks to sections 166(a) (b) to require that Christina have some basis in the debt
for the debt to qualify for deduction as a nonbusiness debt.
Christina is relying on provision 166(d), which specifically says that 166(a) does not apply.
Therefore the requirement under 166(b) of basis does not apply either.
(2) Court relies on Long v. Commissioner to argue that Christina has no basis in the debt
because she is not out of pocket anything as a result of Kevins failure to pay.
Christina does have a basis in the debt. The amount she paid for her children are her out
of pocket expenses and thus her basis.
How should a future Christina avoid the same result in the future?
(1) Re-argue in the Tax Court for new law. Point out that payments to support children,
mentioned in s 71(c), are not supposed to have tax consequences and whats happening
is that she is making payments out of pocket that someone else was supposed to pay.
o A good faith argument that the law is wrong is not a frivolous argument. So dont
fear individual sanction.
(2) Go forum shopping. This is in Tax Court. You can still go to COFC or district court.
(3) Appeal to scholarly commentary. Commentary on good ways to develop the law.
Perry v. Commissioner (note case)
Facts: Same scenario as Diez-Arguelles case. Tax Court didnt budge and got nasty about it.
Courts points: (1) Courts dont legislate. TP can go to Congress if they want a change. (2)
Because TP doesnt get max benefit (she isnt in highest tax bracket), she shouldnt get any
benefit.
McClendon v. Commissioner
Legal fees for litigating these types of deadbeat dad cases are non-deductible also
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Examples: alimony,
educators
expenses,
retirement savings,
higher education
expenses
Minus
Below the Line Deductions
(Either: the standard deduction, 63(c) & supp. p. 646, or itemized deductions, 63(d))
And
Zero
bracket
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Effect on Recipient
Charities dont have to pay income tax. 501.
For our purposes, charities under 501 are the same as charities under 170.
Property Donations
Property held by donor for short-term (one year or less)
Donor can only deduct the basis
Property held by donor for long-term
Donor can deduct FMV
Donor does not have to pay tax on gain
Whats a charity? 170(c), 501(c)(3).
Government, but only if contribution is made for exclusively public purposes
Organization operated for religious, charitable, scientific, literary, or education purposes, or to
foster national or international amateur sports competition, or for the prevention of cruelty to
children or animals
Fraternity of some sort
Organization for war veterans
The earnings of the corporation cant inure to the benefit of any private individual or
shareholder
When Private Business/Person Benefits in Exchange for Charitable Contributions
For businesses:
Rule
Case
COFC/Federal Circuit
If donor RECEIVES or EXPECTS TO
RECEIVE substantial benefit (benefit
that doesnt inure to the public at
large), then donor gets no deduction
Tax Court
If primary or dominant INTENT o
the donor is to get a personal
benefit from the donation, then
no deduction
Ottawa Silica
Facts: Ottawa Silica is involved in
mining operation in southern
California. Donates 70 acres to school
district with knowledge that county
will have to build access roads to
access the donated property. Claims a
deduction for fmv of property. Access
roads will improve access to Ottawa
Silicas mining operations and
increase the value of the land for
when OS sells the property for
residential development.
Held: Because OS received a
substantial private benefit (did not
inure to the general public), it cant
claim a charitable deduction.
DuVal v. Commissioner
Facts: Developer contributed lan
as site for a library. Developer
needed rezoning for a parcel of
property he intended to develop
Held: DuVal can claim a
charitable deduction. DuVal
wanted to give something back
to the community.
For individuals:
Amount of deduction is limited to the excess of the payment to the charity over the value of any
benefit received by the donor
Value of benefit = fmv of whatever is received by the donor
Example:
You bid $2000 for dinner with Buchanan at EJF auction. Normally the dinner would cost you
$200. So you get a charitable deduction of $2000 - $200 = $1800.
Bob Jones University
To get 501(c)(3) tax exemption, the organization has to (1) fall within one of the
specific categories of 501(c)(3) and (2) has to be harmonious with public policy.
If tax exempt organization is racially discriminatory, it will lose tax exempt status.
37
Facts: Bob Jones University is Christian school that forbids interracial relationships. In 1970, IRS
denied it tax exempt status on the basis that it is racially discriminatory and therefore not
consistent with public policy. Bob Jones University sued because it wants to retain tax exempt
status.
Held: Tax exempt status denied.
Majority:
Public policy requirement stems from common law and policy (if everyone has to pay more
tax to make up for the tax exemption, the recipient of the tax exemption should be
something helping everyone).
Congress has acquiesced in the IRS rulings b/c it hasnt done anything to disallow them
even though they are more than a decade old.
Indeed, Congress has enacted 501(i) denying tax exemption for organizations with written
policy of discrimination on the basis of race, color, or religion.
No First Amendment violation because combating racism is more important.
Powell concurrence:
Wants to limit the holding of the majority.
You should lose 501(c)(3) status if you are an openly racist organization.
Tax Credits
Earned Income Tax Credit, 32
Several features:
Amount of credit depends on number of children
Its a refundable credit meaning it doesnt offset tax liability but rather results in
payment from the government
Credit rises as earned income rises and then at a certain point the credit decreases
Marriage penalty when two wage earners get married, their combined EITC is lower than
the sum of their EITCs had they stayed single
Phase in & phase out graph, p 385
Anti-abuse mechanism -- 32(k)
(1) if you fraudulently claim a deduction, you cant get a EITC credit for the next ten years
(2) if you improperly claimed a credit due to recklessness or intentional disregard of rules
and regulations (but not due to fraud), you cant get EITC credit for the next two years
Personal exemptions vs. standard deductions
Personal exemptions counts one per person on tax form
Standard deduction one per tax form
Mixed Business Deductions
Mixed business/personal consumption deduction
Scenario: operate business out of their home, operate a business on the side, buying
pens/paper for your job
Statutory scheme
162(a) allows a deduction for ordinary and necessary expenses paid or incurred in
carrying on any trade or business
The amount that you are trying to deduct has to be greater than 2% of AGI
Example: you make $50k. Expenses would have to be at least $1000 before you get
deduction.
183 business deduction is not allowed if activity is not engaged in for profit
183(d) presumption if TP made profit on the activity in 3 of past 5 years, theres a
presumption that the activity is engaged in for profit
212 covers expense of generating income from sources other than a trade or business
A person with investments in stocks and bonds would claim deductions for fees paid to
investment advisors, subscription to WSJ, and expenses incurred in attending investment
seminars
262 no deduction shall be allowed for personal, living, or family expenses
Nickerson v. Commissioner
Expenses for hobbies are non-deductible. If you are intending to make a profit from
your activity, then you get the deduction.
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Whether or not activity is engaged in for profit is a facts and circumstances test. Factors to
consider:
Manner in which TP carries on activity (is it businesslike with accurate recordkeeping?)
The expertise of the TP or his advisors
The time and effort expended by the TP in carrying on the activity
Expectation that assets used in activity may appreciate in value
The success of the TP in carrying on other similar or dissimilar activities
The TPs history of income or losses with respect to the activity
The amount of occasional profits, if any, which are earned
The financial status of the TP
Elements of personal pleasure or recreation
Facts: TP Nickerson buys a farm in Wisconsin. He wants to transition out of advertising career.
He goes there every weekend during growing season and twice per month during non-growing
season. He mostly works on the home while hes there. Nickerson has experienced losses on
the farm and wants to deduct them under 162.
Held: This is an activity engaged in for profit, so TP can get the deductions.
Appellate court is supposed to apply clearly erroneous standard. Appellate court actually
applies de novo.
Court says people dont do hard labor unless its for profit. What about Iron Man
competitions??
Buchanan thinks the farm is just a man cave so that TP can take a break from family/city
life.
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0.26*23,832 = $6,196
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