tax

1. FUNDAMENTALS OF INCOME TAX
ANALYSIS:
I. Gross Income
A. Does it meet definition of gross income?
1. No: not income
2. Yes: GO TO B.
B. If so, is there a statutory exclusion?
1. Yes: not income
2. No: income; GO TO C.
C. Timing of income inclusion:
1. Sale or disposition?
a. No: outside § 1001.
b. Yes: Calculate Amount Realized (§ 1001(b)) & Basis
(§§ 1011-1016).
c. GO TO #2
2. Sale or exchange?
a. Yes:
i. Gain recognized unless Code provides otherwise (§ 1031)
ii. Loss must be allowed under § 165
b. No:
i. Gift: see Outline at page 10.
ii. Bequest or Devise: see Outline at page 10.
II. Expenses/Deductions
*RULE: An expense is deductible only if specifically allowed by the Code
III. Adjusted Gross Income = GI - deductions
IV. Taxable Income = AGI - personal exemption - (standard deductions OR itemized
deductions)
1

2. FUNDAMENTALS OF INCOME TAX
DON LEATHERMAN'S THREE BASIC TAX LAWS:
1. "Ann Landers Rule": "If it sounds to good to be true, it probably is."
2. "Pigs go to the market, hogs get slaughtered."
3. "Substance prevails over form, except when it doesn't."
I. BASIC PRINCIPLES
A. POLICY CONCERNS (Raising revenue is the purpose - not the policy).
1. TAX POLICY
a. Neutrality or efficiency - Tax system should not affect decisions
about investment or consumption
(1) Income should be taxed only once (matching)
(2) Horizontal equity - Those with the same amount of income
should be taxed the same (Vertical equity is that those who
are better positioned economically should have the same
system).
b. Administrability - Should be simple to understand and easy to
apply for taxpayer (TP) and the government
c. Fairness -
(1) Should take into account the taxpayer's likely (not actual)
ability to pay (liquidity)
(2) Each person should bear the same tax burden
(3) Enforcement should be even and visible
(4) Tax rules should be accessible to all taxpayers
2. ECONOMIC POLICY: Economic Rationality
a. System should spur savings and not curb capital and business
formation. (Why is saving important to the government?
Important for trade).
b. Should not alter investment choices
c. Should not create deadweight losses (resources directed to less
economically efficient investments)
3. SOCIAL POLICY - Should generally be socially neutral - but sometimes
there are incentives for selected social activities or behavior (charities)
4. POLITICAL POLICY - Maxim - An old tax is a good tax.
B. PROGRESSIVITY
1. Embodies the notion that the marginal utility of each additional dollar
diminishes (the more $ you have, the less those extra dollars mean) - so
those with extra dollars pay a higher proportionate amount of tax.
2. Two effects:
a. Income effect - you want more money, you work harder
b. Substitution effect - At some point, the money you would earn
working is not as valuable to you as the time you spend working,
so substitute leisure for more money/work.
3. Example - Income is $45,000 -
a. 10,000 is taxed at the 10% level = $1,000
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3. b. 30,000 is taxed at the 30% level = $9,000
c. Remaining 5,000 is taxed at the 50% level = $2,500
d. TOTAL tax is 12,500.
C. SOURCES OF LAW
1. Statute - Internal Revenue Code of 1986
2. Congressional Records - committee reports
3. Hearings
a. Conference reports - obscure and politically biased. Precedential
value
b. Bluebook report - Attempts to explain the law (not influenced by
politics) - No precedential value.
4. Treasury Department Regulations - Power to create regulations from
Administrative Procedures Act. Challenges are on lack of authority and
abuse of administration
a. Two types
(1) Interpretive
(2) Legislative
b. Forms
(1) Proposed - no precedential value
(2) Temporary - precedential value
(3) Final - precedential value
5. Secretary of Treasury Rulings (revenue rulings)
a. The IRS is bound by them, BUT the taxpayer is not.
b. Less authoritative than regulations
6. Private letter rulings - responses to specific question asked by taxpayers
a. Relevant only to the specific taxpayer
b. No precedential value
c. Filing fee/ time consuming/ may not get ruling in your favor.
D. HOW TO GET TO COURT
3

4. 1. Which court:
a. Tax Court -
(1) Only tries tax cases
(2) The IRS brings the action. If they lose
(a) Acquiesce - agree with the decision
(b) Nonacquiescence - disagree with the decision and
announce it will not follow the decision.
(3) Appeal to Circuit court then Supr. Ct
b. Federal District Court
(1) Taxpayer brings the action
(2) Appeal to Circuit court then to Sup. Ct.
c. Court of Federal Claims
(1) Taxpayer brings the action
(2) Jury trial
(3) Appeal to the Federal Circuit
d. Bankruptcy Court
2. Administration and practice
a. The IRS has 3 years to pursue an assessment.
b. They must give notice of deficiency (90-day letter)
c. The Taxpayer can
(1) Pay the deficiency and then file in claims or district court
(2) Not pay and let the IRS bring the claim in Tax court
(3) Make a Claim for Refund within 3 years from date return
was due, or 2 years from date tax was paid.
d. When in court - usually the facts are stipulated - only the law is at
issue. SO . . . state your facts carefully. (Drescher)
e. Tax system is actually voluntary - however if you don't volunteer,
you are subject to penalties/fines/prison
f. Audits do not happen very often - encourages aggressive tax
reporting - means that honest people pay more taxes. Audits are
done:
(1) At random
(2) When a return looks suspicious
4

5. II. INCOME: If it fits the following definition and is not excluded by the Code or an
administrative concern - It IS gross income.
(1) Originally, GI was defined as "the gain derived from capital, from labor, or from
both combined." Eisner v. Macomber
(a) Very narrow
(b) Excluded windfalls
(2) Next, GI was broadened to include "an undeniable accession to wealth clearly
realized (can be valued/measured) over which the taxpayer has complete
dominion." Glenshaw Glass.
(3) Finally, CODE § 61: Gross income means all income from whatever source
derived, including but not limited to [see list]" (§ 7701 defines 'including' as
not exclusive).
(a) Regs § 1.61-1: Gross income means all income from whatever source
derived, unless excluded by law. Gross income includes income realized in
any form (services, property, meals . . .)
(b) Congress has exerted the full measure of its taxing power under the 16th
Amendment
(c) Chrl: Income tax is source blind: any measurable gain is w/in its reach
(d) Because most income is taxable, most tax planning focuses on postponing
when tax is due; considerations:
(i) ROR on investment
(ii) Risk that investment will lose $
(iii) Probability that tax rate in future will be higher
A. ECONOMIC ACCRETION AND NONCASH BENEFITS
1. TREASURE TROVE AND WINDFALLS
a. Treasure trove IS gross income.
b. Treasure Trove Is taxable when FOUND (Cesarini)
(1) Fairness - until found, no ability to pay the tax
(2) Administrablity - unable to value until found
c. Windfalls are NOT gross income until the money is realized
(usually when the property is sold)
(1) Too difficult to value
(2) No ability to pay tax
d. Examples
(1) TREASURE TROVE - TP found $$$ in a piano -
INCOME when FOUND. Cesarini v. US
(2) BARGAIN PURCHASE - TP buys painting he knows is
much more valuable than price - No INCOME until sold.
(TP does not realize the economic benefit)
(3) PUNITIVE DAMAGES - INCOME NOW b/c clearly
realized/ ability to pay tax (Glenshaw Glass)
(a) The malfeasor actually benefits if these are
excluded b/c it will pay less money and give the TP
the same result (if included, the malfeasor must pay
more to give the TP the same recovery).
***Remember this is just for punitive damages -
other damages may be excluded.***
5

6. 2. Compensation for Services
a. Cash payments: § 61
(Welfare & gov't payments for victims of crime or
disaster not w/in contemplation of § 61 - KB 156)
b. Non-cash receipts
i. ECONOMIC BENEFIT
(A) Employer-purchased annuities ARE GI to the
employee even if there are some restrictions.
Drescher (although TP here could have argued that
the value is less b/c of restrictions - if proven could
include a limited amount of income)
(1) Accession to wealth? EE has a bundle of
rights he didn't have before
(2) Clearly realized?
(a) Fairness: can TP pay the tax?
(b) *Administrability: can it be valued?
How much would it cost the TP to
get the benefit?
(3) Complete control/dominion? *In 3d
party's hands (company's creditors could not
get to it)
(B) An unfunded (not out of ER's hands/control) and
unsecured promise to pay by an ER to an EE is
NOT GI. § 83
-> Not clearly realized: what is the value of a
promise to pay?
(C) The issue in Drescher is really WHEN the taxpayer
will pay the tax - now or later?
(1) Deferral reduces the present value of the tax
burden.
(2) The taxpayer would always prefer to pay tax
later
ii. BARTER EXCHANGES - the exchange of services IS
included in gross income. Rev. Ruling 79-24 (124-25)
(A) Administrability
(1) FMV of the services or property
(2) If one side has clear value and the other
doesn't & arms'-length transaction, use the
same amount (flows from the assumption
that people make even exchanges)
(3) If services rendered at stipulated price, that
price rebuttably presumed to be FMV
(B) Fairness: otherwise, those who barter would pay
less tax and those unable to barter pay more.
(C) The easier it is to value the services, or the more
commercial in nature the exchange is, the more
likely that it will be considered gross income.
(1) Lawyer/Painter - INCOME
6

7. (2) Artist/Landlord - INCOME
(3) Babysit for your neighbor - NOT INCOME
(too hard to value and keep track of)
Regs 1.6045-1(a)(4): taxable barter does
not incl. arrangements that provide solely
for the informal exchange of similar
services on a noncommercial basis
(4) Enter into babysitting coop where you either
Babysit or pay - INCOME (if worked at job,
made $50, and paid it to coop, would have
income); one event of working for center
constitutes two tax events: [*see HO]
1. Income event: gives work for
center & receive an economic
benefit in return
2. Expense event: gives center an
economic benefit (work hours) to
watch child
(5) Barter Club - INCOME
(6) No interest/No service charge checking:
meets definition of income, but is NOT
taxed b/c banks prefer the no interest/no
service charge route and banks are powerful
lobbyists
7

8. B. STATUTORY EXCLUSIONS – Non-cash benefits that would be income under
the definition, but are NOT because they are excluded by the CODE. ALL
EXCLUSIONS CONSTRUED NARROWLY. If does not meet the definition of
the exclusion, it still must meet the definition of Gross Income under § 61.
1. IMPUTED INCOME: Where a person uses his own household durable
(personal residence, car or television) or services to provide an economic
benefit to himself or his family.
a. NOT subject to tax
i. Too difficult to value/Not clearly realized (but even if
clearly realized, excluded by statute)
ii. Cost of reporting and enforcement
b. Problems (SM 19-20)
i. Sam is a vegetable grower, does he (or anyone else) have
GI when:
(A) He harvests the vegetables - NO (imputed income)
(1) Economic benefit - Y
(2) Over which he has complete dominion - Y
(3) Clearly realized - No - (difficult to value
and impossible to enforce)
(B) He and his wife consume the vegetables - NO
(imputed income) - Same as above
(C) Sells the veggies for $100 - Y
(D) Exchanges veggies for tuna Charlie caught - Y -
barter exchange
(E) Sam sells his veggies in the store ($50 worth of sq.
footage) and pays no rent but keeps the proceeds -
(1) The grocer has a $50 benefit (Sam's veggies
bring in more business) and Sam has a $50
benefit because he doesn't have to pay rent
(a) Sam has income and a deduction
(b) The Grocer has $50 income and can
offset his total income with his total
rent expense ($400)
(2) If the grocer lets Sam use the space as a gift:
(a) Sam has neither income nor a
deduction
(b) The Grocer has no income and his
rent deduction should not include the
amount of money he pays for the
space given to Sam (350)
(3) If the Landlord is Sam's father - Less like
income
ii. M saves 50 cents with a coupon - income? - No.
(A) Accession to wealth - Y
(B) Dominion - Y
(C) Clearly realized -Y (but impossible to enforce and
keep up with)
8

9. 2. MEALS AND LODGING
a. Employer Convenience Doctrine was the common law doctrine
whereby meals and lodging that benefited the employer or were
part of the job were NOT income. Benaglia (hotel manager)
b. § 119 allows the exclusion if the requirements are met:
i. Meals
(A) Furnished to the EE/TP, spouse and/or any
dependents
(B) By/on behalf of the ER
(C) For convenience of ER (construed narrowly:
exigent circumstances only/EE has to be at work
site during meals)
(D) On the business premises
ii. Lodging
(A) Furnished to the EE/TP, spouse and/or any
dependents
(B) By/on behalf of the ER
(C) For convenience of the ER (construed narrowly:
exigent circumstances only/EE has to be at work
site during meals)
(D) Employee is required to accept such lodging on the
business premises as a condition of employment
c. The Code section really creates a lot of ambiguities.
DL: the more tied to business operations something is,
the less it is treated like income
Chrl: trend in Code to treat EEs more favorably when
"forced" to accept a benefit
d. *FOR CASE INTERPRETATIONS, SEE KB 94-7
e. The policy behind this is Congress' willingness to cut employees a
break when their freedom to choose is restricted.
f. § 274(n) Employers can only deduct 50% of meals and
entertainment.
g. § 274 does not include lodging in the 50% limit - so lodging
received as part of the job under § 119 is fully deductible.
h. COMPARE TO A TRAVELLING SALESMAN TYPE
SITUATION
i. The travelling salesman is compelled to eat out and stay in
hotels - he gets a deduction
ii. The hotel manager is compelled to live in the hotel - he
does not have to include the value in his gross income.
i. Prob. 4, p.99 - E moves to LA b/c of job and gets $18,000 housing
allowance increase - taxable? - Yes
i. No real accession to wealth
ii. He is better off compared to those in LA
iii. Administratively difficult to account for cost of living
changes
iv. Look to objective facts
9

10. 2.5. FRINGE BENEFITS
a. "No-additional cost service" (ex: free standby flights to airline
employees)
b. "Qualified employee discounts": sales of merchandise to
employees at cost
c. "Working condition fringe": parking, security
d. "DE MINIMUS FRINGE"
i. § 132(a)(4); Regs 1.132-6(a): any property [DL: generally
other than cash] or service the value of which (after
considering frequency) is so small that accounting is
unreasonable or impracticable. [Statutory enactment of
"clearly realized" component of Glenshaw Glass income
definition]
ii. Policy behind this is administrative convenience
iii. *See 1.132-6(e) for examples:
(A) Occasional typing personal letters
(B) Occasional use of a copy machine
(C) Occasional cocktail parties/ group meals / or
picnics
(D) Traditional birthday or holiday gifts with low
market value
(E) Occasional sporting event tickets (not season
tickets)
3. LIFE INSURANCE
a. § 101(a)(1) - Money received from payment of a life insurance
contract is NOT included in GI if paid because of the death of the
insured. (Like a bequest)
b. Life insurance is more beneficial to those who die earlier. Those
who die later pay more money over the years (putative tax).
4. GIFTS, BEQUESTS, DEVISES: § 102 - generally excludes from GI the
value of property acquired by gift, bequest, devise or inheritance (but
NOT any income received from that property and not a gift of income
from property).
a. DE has no income, and DR has no deduction
b. To determine if something is a gift - look to:
i. The objective intent of the transferor (NOT whether TR
characterizes it as a gift and NOT the expectation of TE)
(A) If given out of some moral or legal duty, NOT a
gift and INCLUDED in GI.
(B) If given in payment of or recognition of (retiring
EEs) a service, NOT a gift.
(C) If given from incentive of anticipated future
benefit, NOT a gift
(D) If given with detached and disinterested generosity,
it's a GIFT
ii. Common understanding of the parties
iii. Deductions taken?
(A) If the TR takes a deduction (business expense) -
10

11. then it probably is NOT a gift. The TE must report
the value as income so it will not escape the tax
system
(B) If the transferee does NOT take a deduction - it
looks more like a gift given from after-tax dollars.
iv. Decided on a case by case basis by the TF
v. Examples (What is a gift?)
(A) Duberstein - Really 2 cases
(1) Cadillac given to business assoc. as a "gift"
(NOT a gift); Ct. looked to:
(a) Although not ER-EE, service
provided to TR by TE (sending
customers); expectation of continued
relationship
(b) Deducted as a business expense
(2) Money given to church employee upon
leaving (Looks like severance pay, but
remanded to TF)
(a) No deduction by church
(b) No continued service
(B) Olk v. US - Pit bosses wanting to exclude their
"tokes" (tips)-
(1) Probably fits the Duberstein definition:
payment for a service (like tips)
(2) DRs sort of get deductions when they give
tokes (b/c they are only taxed on NET
winnings); the deduction of the DR should
be matched by the DE with inclusion.
vi. Transfers between people w/ social relationships usu.
GIFTS: Payments to mistresses usu. gifts; payments to
prostitutes usu. income
c. § 102(c): § 102 does not exclude gifts from ERs to EEs
i. § 132(e): allows exclusion if de minimus fringe benefit
ii. § 274(b)(1): $25 limit on business gift deductions per
donee per year under §§ 162 and 212.
iii. § 74 allows deduction for EE achievement awards
d. Bequests, devises, inheritance NOT income unless a transfer in a
will in exchange for services
e. Prizes and awards NOT EXCLUDED (INCOME)
f. Scholarships and fellowships EXCLUDED only to extent
required to pay for education expenses; any excess and any amt. in
exchange for teaching, research or other svcs., NOT EXCLUDED
11

12. *5. INTEREST ON STATE/LOCAL BONDS *(KB 277-79, 282-84; SM
20-22)
a. § 103: interest paid on municipal (state/local, incl. D.C.) bonds is
EXCLUDED from GI (intended to benefit state and local gov'ts:
can pay lower rate of interest than other bonds)
b. Types of bonds:
(1) PREMIUM - Sells for $110, pays 10%/yr and repays $100
at end of 5 years - yields $155.
(2) DISCOUNT - Sells for $50, pays no interest and repays
$100 at end of 5 years - yields $100
(3) PAR - Sells for $100, pays 7% interest and repays $100 -
yield $135.
c. When a taxable fed bond is issued to a 30% TP for $1000, paying
10%, the TP gets $70 in interest & the fed gov’t gets $30 in tax.
But when a nontaxable state/muni bond is issued at 7%, the TP
still receives $70, but the $30 that would have been paid to the fed
gov't is kept by the state/muni gov't (never paid out in interest to
begin with).
e. Tax expenditure: tax rev. loss to fed. gov't b/c of tax exemption
f. Putative tax: difference between interest rate on tax-exempt and
taxable bonds; TP willing to receive lower interest rate on tax-
exempt bonds; intended benefit to state/local gov't.
g. Dead weight cost: unintended benefit to high-bracket TPs when
their tax savings exceed the putative tax because they don't
demand enough exempt bonds and state/local gov't must price the
bonds to appeal to lower-bracket TPs (lower putative tax)
-> ex: 30% TP not willing to accept < 7% return on tax-exempt
(if taxable paying 10%), so state/muni must give
7%; but 40% TP can also buy at 7%, saving 40%
tax but paying only 30% putative tax; state/muni
gets 30% putative tax and 40% TP gets 10% dead
weight cost advantage
*since most investors in tax-exempt bonds are high-bracket TPs,
many argue that they are inefficient means of fed. subsidy
*h. Issue of horizontal equity: see KB 278-79
i. Can produce economically irrational behavior: people who are tax
averse will choose the tax-exempt bond even though the after-tax
return is higher on the taxable bond.
-> ex: When $1000, 10% taxable bond is issued to a 20% TP, TP
gets $80 and fed gov't gets $20. But if it were nontaxable
with a 7% interest rate, the TP would get only $70. TP
should buy the taxable bond. Eventually, the state will
raise the interest on the nontaxable bonds.
j. tax arbitrage: buying an asset in one market & selling nearly
identical asset in another market, w/ sole objective of taking
advantage of differing tax regimes in the two markets;
-> § 265(a)(2) prohibits deduction for interest on debt
incurred to buy tax-exempt obligations
** Chrl: "True Value of a Tax Preference"
12

13. 6. RECOVERIES FOR PERSONAL AND BUSINESS INJURY
a. Two themes:
i. Congress and courts are reluctant to tax payments received
under hardships or involuntary payments
ii. consistency: costs to produce human capital/income not
deduction, so recovery for losses should not be incl. in
income. (Not true in business setting.)
b. § 104: EXCLUSIONS
i. 104(a)(1) - Worker's Comp received for personal injuries
or sickness EXCLUDED
ii. 104(a)(3), 105, 106: benefits received from ER-provided
health ins. are EXCLUDED (unless EE took deduction for
costs of ins.)
iii. 104(a)(2)
(A) Damages received to compensate for personal
physical injuries or sickness are EXCLUDED
-> punitive damages generally INCLUDED in GI
(B) Damages for lost wages & emotional distress
EXCLUDED if result of physical injury or
sickness
-> if not a result of physical injury/illness,
EXCLUSION DOES NOT APPLY
(C) This is not a postponement of income provision, but
a tax forgiveness provision - so if one were to
receive property in lieu of cash - his basis would be
that of the tortfeasor - not 0 (which is what he has
in it). 104(a) intends to exclude taxation of these
awards, if the TP were to take a zero basis, he
would eventually pay tax on the award - contrary to
the CODE.
*SEE STRUCTURED SETTLEMENT MATS.
13

14. C. BASIS: INTRODUCTION TO REALIZATION AND RECOGNITION
-Income does not include recovery of one's capital (avoid taxing a dollar of
income more than once); basis denotes the investment in capital which is
recovered upon sale or other disposition (any transfer of property for cash,
assumption of liabilities, or property materially different in kind or extent)
(not gifts, devises/inheritances or like-kind exchanges)
1. General Rule (A/R – B = gain or loss)
a. § 1001: On sale or other disposition of property:
(a) Realized Gain = amount realized - adjusted basis for
determining gain (G=AR - Bg).
Realized Loss = adj. basis for determine loss – AR
(L = Bl - AR)
*in this course, only time Bg & Bl are different is with
gifts
(b) AR = $ received + FMV of property received + liabilities
assumed by TE
(c) Unless otherwise provided, the realized gain or loss is
recognized.
b. § 1011: Bg/Bl = basis determined under § 1012 (or other section;
see capital gains & losses), adjusted as provided in § 1016.
c. § 1012 - Basis of property is the cost of property ($ given + FMV
of property given + liabilities assumed) (except as provided in
other sections; see capital gains and losses)
d. § 1016: adjustments to basis:
(A) capital expenditures
(B) depreciation/amortization deductions
e. § 61(a)(3) - Gross income includes recognized gains from dealings
in property.
f. Examples (SM, 27-33): P buys land for $200 then sells it to R for
$250.
(A) Bg=$200 (§ 1012)
(B) Amt. Realized=$250 (§ 1001(b))
(C) Gain realized=$50 (§ 1001(a))
(D) Gain recognized=$50 (§ 1001(c))
(E) R's basis=$250 (§ 1012)
g. *ALLOCATION - When the transfer is for/of more than one
thing, you must allocate the B/AR to each thing to determine the
gain/loss.
(A) B for ea. asset = (FMV of individual asset at time received/
FMV of all assets at time received) x cost.
AR for ea. asset = (FMV of individual asset at time
transferred/FMV of all assets at time transferred) x AR.
(B) Example: R buys land (FMV=200) and building
(FMV=800) for $1000. The building is depreciated to 500.
The land (FMV=150) and building (FMV=650) are then
sold to C for $800.
(1) LAND
(a) B in Land = (200/1000) X 1000 = 200.
(b) AR for land = (150/800) X 800 = 150
(c) Loss = 200-150 = $50
14

15. (2) BUILDING
(a) B=((800/1000) X 1000) - 300 = 500.
(b) Amount realized = (650/800) x 800 = 650
(c) Gain = 650-500 = 150
(3) C's B (land) = 150 and B (bldg.) = 650
*h. For the EXAM - be able to discuss the following and know the
section #s
(A) basis
(B) adjusted basis
(1) depreciation
(2) capitalized expenditures
(C) amount realized on sale or disposition
(D) realized gain or loss
(E) recognized gain or loss
(F) basis taken by the transferee
2. Special Basis Rules
a. BEQUESTS OR DEVISES: § 1014: the basis taken by DE =
FMV of the property at the time of the decedent's death.
(1) If the decedent's basis was less than FMV, the basis is
raised (tax advantage)
(2) IF the decedent's basis was more than FMV, the basis is
lowered (tax disadvantage -> good to distribute before
death)
b. GIFTS: § 1015:
(1) DE's B = DR's B except:
(2) If DR's B > FMV at time of the gift, then DE's Bl = FMV
(tax disadvantage: increases future G or reduces future L ->
should sell property & realize loss, then give cash).
* (3) In other words:
(a) DE's Bg = DR's B
(b) DE's Bl = lower of DR's B or FMV at time of the
gift.
(4) Example: DR's B = $2,000, FMV = $1000
i) GAIN
a) AR = $2,500
b) Basis = $2,000
c) $500 gain realized
ii) LOSS
a) AR = $500
b) Basis = $1,000 (FMV lower)
c) Loss = $500
iii) IN THE MIDDLE (any amount between
15

16. and including 1,000 - 2,000.
a) Amt. Real - $1,500
b) Bg = $2,000, so no G
c) Bl = $1,000, so no L
(5) DR's B = $1,000, FMV = $2,000
(a) GAIN
i) Amt. realized = $2,500
ii) Basis = 1,000
iii) Gain = $1,500
(b) LOSS
i) Amt. realized = 500
ii) Basis = 1,000
iii) Loss = 500
iv) *Remember: DE has no income until the
gift is sold or transferred.
c. MARRIAGE PROPERTY: § 1015(e); § 1041:
(1) No gain or loss on transfer or property between
(a) spouses
(b) former spouse if the transfer is incident to the
divorce
(2) DE's B = DR's B.
D. TREATMENT OF TAXPAYER'S DEBT OR OBLIGATION
1. LOAN PROCEEDS: When A borrows $100 from B,
a. A has $100 in cash, but a $100 obligation: no NET increase in
wealth, NO INCOME.
b. B has $100 less cash, but an acct. receivable for $100:
NO DEDUCTION (voluntary; get personal satisfaction).
2. SATISFACTION OF DEBT: When B satisfies the debt:
a. As a gift or in exchange for A's $100:
(1) A has NO INCOME OR LOSS. (Gift: § 102)
(2) B has NO DEDUCTION
b. In exchange for A's services:
(1) A has $100 less debt obligation: COMPENSATION
INCOME. § 61(a)(1).
(2) B has NO DEDUCTION
c. In exchange for A's property:
(1) A has G/L = difference between AR (amt. of debt
satisfied) and adjusted basis of the property given.
§ 1001(a)
(2) B has NO DEDUCTION.
3. CANCELLATION/DISCHARGE OF DEBT
a. § 61(a)(12) - Gross income includes cancellation of
16

17. indebtedness income.
(1) If creditor accepts $600 (cash and/or property) on a $1000
debt, $600 has been satisfied and $400 has been cancelled/
discharged
(2) Why would a creditor cancel debt?
(a) The debtor cannot repay the full loan: agree to
accept < full amt. in order to get something
(b) If interest rates are rising, the value of the debt will
decline - so the creditor simply accepts less now.
(3) TP has not reported any of the money received as income
because it was assumed he would repay it. If he is NOT
obligated to repay it, he MUST include this amount in
gross income
*(a) Debtor has Gross Income (§ 61(a)(12)) unless
limited by § 108.
*(b) Creditor may have a deduction. § 165
(4) Examples:
(a) Stock (B=40, FMV=100) used to pay $150
debt.
i) $100 satisfaction with $60 Gain. § 1001(a)
ii) $50 COD possible income. § 61(a)(12)
(b) G gets $1000 recourse loan from S using stamp
collection (B=400) as collateral. Later, when loan
balance is $900, S accepts the stamp collection
(FMV=700) and extinguishes the loan.
i) $700 satisfied = AR on property
ii) G on disposition of property = AR - B =
700-400 = 300 gain
iii) COD = $200 (incl., subj. to § 108
limitations), unless a gift (excluded; debt
satisfied)
(c) Kirby Lumber (U.S. 1931): Corp. issued
$1,000,000 worth of bonds (received a loan), then
bought the bonds back for only $862,000. (Assets
were CASH $1,000,000 and DEBT $1,000,000;
NOW Assets are CASH $138,000 and DEBT = 0).
The 138,000 COD was included in Gross Income.
(d) Zarin (3d Cir. 1990): Gambler borrowed $3.5 mill
and lost it gambling. Resort took $500,000 in
satisfaction of debt (cancelled $2.9 million. The
2.9 million should have been GI - but the ct. found
that:
i) the debt was not legally enforceable
ii) amt. of debt in dispute: the settlement
served to fix the amt. of debt, not reduce it, based
on parties' informal understanding that he would
17

18. return first $3.5 mill [DL: like a partnership –
“pity” case].
b. EXCEPTIONS: § 108 EXCLUDES certain types of cancelled
debt from GI
(1) Bankruptcy discharge: exclude the entire amount of
Cancellation of Debt (COD) from gross income. § 108(a)
(1)(A)
(2) COD income is reduced by amt. by which the debtor is
economically insolvent (amt. by which liabilities > FMV of
assets). §§ 108(a)(1)(B), 108(a)(3)
(a) A buys a house for $125,000 w/ $100,000 borrowed
money.
i) FMV of house goes down to $92,000:
debtor is insolvent in the amount of $8,000
ii) The creditor agrees to take/satisfy $52,000
and cancel $48,000.
iii) The debtor has gross income of COD except
that which is excluded by his insolvency:
$48,000 - $8,000 = $40,000 COD income in
GI
iv) A tax attribute (ex: basis of the property) is
reduced by exclusion ($8,000), preserving
the gain so that the tax will be recaptured
later (exclusion is a "now or later" question).
(3) § 108(a)(2)(A): if bankruptcy discharge and insolvent, can
exclude entire amt. of COD
4. PAYMENT OF THE DEBT OF ANOTHER: When someone pays your
debt, you have economic income.
a. Old Colony Trust (U.S. 1929): ER paid EE's fed. inc. tax
($700,00) on his salary of $1 million. Court held that EE must
include $700,000 in GI.
b. Clark (BTA 1939): atty. missed opportunity to save TPs $20K in
taxes; atty. paid $20K to TPs; ct: no income because actually
compensation for a loss
5. TRANSFERS OF PROPERTY ENCUMBERED BY DEBT
a. ASSUMPTION OF RECOURSE DEBT
Recourse debt: creditors can look to ANY of debtor's ASSETS to
satisfy debt.
(1) § 1.1001-1(e): In part sale, part gift transaction,
transferor has G = AR - B; NO LOSS if B > AR
(2) *treated entirely like a gift if consideration to DR < DR's B
immediately before transfer
-> no G/L for DR
-> DE's B = DR's B except, if DR's B > FMV at the time of
the gift, then DE's Bl = FMV
*(3) Treated entirely like a sale if consideration to DR > DR's B
immediately before transfer
Example: Deidrich (US 1982): Parents gave stock to kids
18

19. as gift w/provision that kids would pay the gift tax.
(Payment of the tax is like the recourse debt)
(a) AR = $63,000 (amt. of debt assumed)
(b) DR's B = $51,000
(c) DR's G = $12,000.
(d) DE's B = $63,000
(4) Part sale/part gift to a charity: § 1011(b)
(a) Because the TP gets a deduction for charitable
contributions, you apportion the basis to the amount
of the gift
i) EXAMPLE - S gives stock (B=40;
FMV=100) to the United Way for $25
a) S has a $15 gain ($40 basis x 25/100
= $10) $25 - $10 =$15
b) S also has a $75 charitable deduction
c) UW has a $25 basis
ii) Gives same stock to UW for $50
a) S has a $30 gain ($40 basis x 50/100
= $20) $50-20 = $30.
b) S also has a deduction of $50
c) UW has a basis of $50.
b. NON-RECOURSE DEBT: The lender gives you the loan and
will accept EITHER the full amount of cash, OR the property (put
option). (The lender bears the risk of a decline in the property.)
(a) Where the debt is satisfied with the property, the
value of the prop. is irrelevant. Reg. § 1.1001-2(b)
i) There is NO COD
ii) There IS gain or loss: AR = amt. of debt
discharged. Reg. 1.1001-2(a)
(b) Where a buyer, not the bank, assumes the debt, AR
= debt taken "subject to" + any $/property received
(FMV is irrelevant).
E. TIMING OF INCOME INCLUSION
1. ANNUAL ACCOUNTING: § 441(A): Tax is determined and reported
on an annual basis, usually on a calendar year.
2. CONSEQUENCES OF ANNUAL ACCOUNTING
a. TRANSACTION SPANNING TAX YEARS: Because some
businesses have fluctuations in income expenses over years, the
Code allows the business TP to file amended returns to offset gains
and losses. § 172 - BUSINESS LOSSES - net operating losses
(excess of deductions over gross income) can be carried back 3
years, or forward 15 years.
b. TAX BENEFIT RULE - § 111(a): If the deduction of an item
offsets taxable income in the prior period, then the subsequent
19

20. recovery of the item is included in the taxpayer's income only up
to amt. of reduction in taxable income from earlier deduction,
even if tax amts. are different.
(1) INCLUSIONARY - Alice Phelan - TP gave prop to charity
w/condition and took deductions. When condition was
broken, TP got the land back and had to include it in gross
income.
(2) EXCLUSIONARY - Clark - TP lost money b/c of bad
advice from atty. and took NO deductions. When he
recovered the money later, no income had to be reported.
(3) Applies only when the later event is fundamentally
inconsistent w/ the premise underlying the earlier
deduction (if 2 events had occurred in the same year,
would have foreclosed the deduction). (Tax symmetry re:
the indiv.)
c. CLAIM OF RIGHT DOCTRINE: § 1341
(1) Requires that income be included when the TP has a legal
claim of right to it (even though its ultimate ownership
may be in dispute North American Oil v. Burnet), BUT
(2) provides that if the income is later taken away and had
been taxed and the deduction exceeds $3,000, the taxpayer
can pay the lesser of:
(a) tax in the later year with the deduction, or
(b) tax in the later year without the deduction, but
reduced by the amount the earlier year would have
been decreased if the income were lower.
d. Claim of Right and Tax Benefit Rule are converse rules.
(1) Claim of Right addresses TP who receives money in one
year and then gives it back.
(2) Tax Benefit Rule addresses TP who paid too much and
took a deduction, and then got the money back.
3. REALIZATION AND RECOGNITION ISSUES
a. Generally, gain is recognized when realized. § 1001(c)
(1) Before realization, difficult to value, TP may not have $ to
pay tax, unrealized gains in one yr. might turn into
unrealized losses the next yr. Tax system does not reach
mere changes in property value. Must be a transaction or
"tax event."
(2) When is there a realization? The Code does not provide a
clear test for when there is realization of income.
*Eisner v. Macomber (U.S. 1920): receiving a stock
dividend is NOT INCOME because no realization ->
substance over form doctrine.
(a) There is realization if there is an exchange of
MATERIALLY DIFFERENT things. § 1001(a),
Cottage Savings.
(b) Materially Different is a LOW threshold:
Cottage Savings (U.S. 1991): TP trades a mortgage
investment portfolio to a bank for a different
20

21. mortgage investment portfolio (FMV down, desire
to realize a deductible loss of B-FMV): Ct held they
were MATERIALLY DIFFERENT because they
were LEGALLY DISTINCT ENTITLEMENTS
(risks might be different).
b. LIKE-KIND EXCHANGES: Gain realized but recognition
deferred under "nonrecognition provisions" (continuity of
investment). § 1031
[§ 1001(c): unless otherwise provided in the Code, realized gain or
loss is recognized].
(1) § 1031(a)(1): Exchanges solely for like-kind property
i) There is no gain or loss recognized on the
exchange of:
a) property held [subst. req't] for
productive use in a trade or business
or for investment [if not used solely
for personal purposes, fits
definition];
b) exchanged solely for like-kind
property also to be held [subst.
req't] for productive use in trade or
business or for investment
ii) SO, there may be a realized gain under § 1001 that
is not recognized under § 1031.
iii) Does NOT apply to:
a) property for personal use
b) stock in trade or other property held
primarily for sale § 1031(a)(2)(A)
c) stocks, bonds. or notes § 1031(a)(2)
(B)
d) other securities or evidences of
indebtedness or interest § 1031(a)(2)
(B)
iv) § 1031(d): If there is an exchange of solely like-
kind property, the new property has the same basis
as the old property (B2 = B1) (preserves gain or
loss)
v) This section is MANDATORY (keeps TPs from
recognizing losses and deferring gains)
vi) Like kind:
a) Refers to the nature or character of the prop,
not the grade or quality. ∋1.1031(a)-1(b)
b) Unimproved real estate and improved real
estate are like-kind (different quality).
c) Old truck/car for new truck/car to be used
for same purpose is like-kind
vii) Look at each side of the transaction separately
viii) 1031(a)(2) - Someone who holds property primarily
for sale (real estate dealer) cannot take advantage of
this.
21

22. ix) EXAMPLE - J owns land for investment w/
$15,000 basis and $25,000 value. T owns land for
investment w/ $18,000 basis and $25,000 value.
They exchange
a) J realizes a $10,000 gain but does NOT
recognize it b/c she will hold T's land for
investment.
b) T has a $7,000 realized gain - also not
recognized b/c T holds J's land for
investment.
x) It wouldn't matter to J if T did NOT hold his
property for investment; as long as she intended to,
she does not realize a gain.
(2) BOOT: If exchange of like kind property with something
else thrown in the deal (to boot: cash, stock, etc.)
(a) G, if any, is recognized up to the value of the boot
§ 1031(b) (recognizing the gain on the boot, but not
on the like-kind portion of the exchange)
(b) No L recognized!
(c) Basis for property received = Basis of property
transferred - boot received + G recognized - L
recognized
(B2 = B1 - boot received + recG - recL)
*same as B = V - unrec. G + unrec. L*
(d) Person giving boot along w/ like kind property is
treated as making two exchanges:
i) like kind property for a portion of the other
like kind property AND
ii) boot for the rest of the like kind property
(d) Example: T owns Tract 1 with Basis of 20,000 and
value of 25,000. S owns tract 2 with Basis of
18,000 and value of 21,000. They trade AND S
gives T stock worth 4,000 (or cash $4,000).
i) T has:
a) real G of 5,000 (1,000 from prop. +
boot)
b) but he only recognizes $4,000 (the
amt. of boot).
c) His basis in tract 2 is the basis of the
old property, less any boot, plus gain
recognized or less loss recognized.
§ 1031(d) So: 20,000 - 4,000 +
4,000 = 20,000. (preserves the 1,000
gain not recognized for later)
ii) S is treated as exchanging:
1) $4000 for 4/25 of tract 1 (no real G/
L; AR = B = 4000) AND
2) tract 2 for 21/25 of tract 1 (real G =
AR- B = 21000 - 18000 = 3000; not
22

23. rec.) (B1=B2=18000)
3) TOTAL BASIS in tract 1 =
4000+18000=22000 (preserves her
3000 unrecognized G b/c V=25000)
iii) If T's basis in tract 1 had been 23,000:
1) T has a realized gain of 2,000. Not
greater than boot - so 2,000 is
recognized.
2) T's new basis is § 1031(d) the basis
of the old property, less any boot,
plus gain recognized or less loss
recognized. 23,000 - 4,000 + 2,000
= 21,000. (=V)
iv) If S had given stock (V = 4000; B = 2500)
instead of the $4000 cash, treated as making
two exchanges:
1) stock for 4/25 of tract 1 (real G=AR-
B= 4000-2500=1500; recognized
under 1001(c)) (B = 4000); AND
2) tract 2 for 21/25 of tract 1 (real G =
21000 – 18000 = 3000; not recog’d.
under 1031) (B1=B2=18000)
(TOTAL BASIS = 18000 + 4000 =
22000 (preserves unrec’d G of 3000)
(f) If unequal exchange, ask whether just a bad bargain
or a gift is intended.
(3) Other nonrecognition situations:
(a) involuntary conversions § 1033
(b) SALES OF PRINCIPLE RESIDENCE § 1034
i) MANDATORY provision
ii) No recognized gain if proceeds from sale
are reinvested in a residence (equal or
greater cost) within 2 years (before or after).
iii) If the new residence costs less, recognized G
is the difference.
iv) Basis in the new property is the cost less any
unrecognized gain.
(c) wash sales for tax avoidance § 1091
c. Potential gain eliminated - two ways NEVER to have to pay the
gain
(1) § 121(a) & (b) - ONE TIME EXCLUSION of gain from
sale of principle residence if:
(a) TP is 55
(b) prop sold has been principal residence for 3 yrs.
(c) exclusion not to exceed $125,000
(2) § 1014(a)(1) - basis of property acquired from decedent is
23

24. the FMV of the prop at decedent's death
4. CONSTRUCTIVE RECEIPT AND ECONOMIC BENEFIT
*a. ECONOMIC BENEFIT: amt. paid to 3d party on behalf of
TP: payor has no rts. left to it (irrevocably out of their hands;
not subj. to payor's creditors)
(determines when TP accts. for something received)
(1) Cash method TP accts. for asset when received (actually or
constructively), but only if it is clearly realized (able to be
valued). If it can't be valued (uncertain promise of future
payment), it is not yet an economic benefit.
(2) EXAMPLES:
(a) $ deposited in your acct. is an economic benefit, even if
you can't withdraw rt. away (not a constructive receipt
issue)
(b) An unfunded, unsecured promise to pay is not an
economic benefit. § 83 (funds not irrevocably out of
promisor's hands) (see if constructive receipt)
b. CONSTRUCTIVE RECEIPT: If an asset is available to the TP
without substantial limitation or restriction, the TP will be
deemed to have received it. (determines when TP treated as
receiving)
*Applies only to promises to pay (if already paid to TP or 3d
party for TP, it's an economic benefit)
(1) Examples of substantial limitations:
(a) have to give up a legal rt.
(b) wages/dividends credited, but can only be received
through mail (or practice is always to mail) (or can
be picked up, but would have to drive from Knox to
Memphis.
(2) Examples of constructive receipt:
(a) interest accruing on a bank account is
constructively received
(b) matured interest coupons which can be cashed at
any time
(c) wages avail. by direct deposit or pickup, even if EE
chooses to have check mailed
(d) dividends avail. upon demand
(e) checks received: even if can't cash/deposit, can
negotiate (different from mere unfunded promise)
(assumption that checks will be honored: income
when received; if not honored later, no income
anytime: correct earlier inclusion)
*c. ANALYSIS:
24

25. (1) Is there (a) an economic benefit which can be valued or (b)
an unfunded, unsecured promise to pay?
(a) clearly realized -> income
(b) not clearly realized; go to (2)
(2) Are funds avail to TP w/o substantial limitation or
restriction?
(a) YES: constructive receipt -> income
(b) NO: no income yet
d. EXAMPLE: Amend - farmer sold wheat in 1944 but K required
receipt of payment in 1945 - NO economic benefit b/c no K rt. to
payment earlier; if agreement for payment is before payment
earned, courts will not ask what other K could have been made
25

26. II. DEDUCTIONS FROM GROSS INCOME FOR EXPENSES
A. IN GENERAL: An expense is deductible only if specifically allowed by the
CODE.
1. *AGI for individual = GI minus deductions. § 62. Deductions include:
a. Costs of producing income. § 62(a)(1)
b. Certain trade/bus. deductions of Ees. § 62(a)(2)
c. Certain losses from sale or exchange of property. § 62(a)(3)
d. Certain rents & royalties. § 62(a)(4)
2. Statutory scheme:
a. § 63: taxable income defined (standard deduction, itemized deds.)
b. § 67: misc. itemized deds. allowed only as exceed 2% of AGI
c. § 68: overall limitation on itemized deds.
d. § 161: deductions specified in §§ 162 et seq. are allowed
deductions, subject to exceptions in §§ 261 et seq.
* 3. Three questions to ask in regarding expenses:
* a. SHOULD COST BE CAPITALIZED (no ded.)?
* i. Used to acquire an asset - capitalize
* ii. Used to create an asset (build a house) - capitalize
* iii. Used to add value to an asset, prolong its useful life, or
adapt it to a different use (add porch onto house): probably
capitalize, but not if:
* (A) Done in anticipation of sale?
* (B) Done because of compulsion?
* b. If not capitalized, is it a DEDUCTIBLE BUSINESS EXPENSE
(rble. business person would incur the expense)?
* c. If not, is it one of the LIMITED DEDUCTIBLE PERSONAL
EXPENSES?
B. CURRENT EXPENSE V. CAPITAL EXPENDITURE/LONG-TERM
BENEFIT
*§ 263(a): NO DEDUCTION for capital expenditures:
(1) new buildings or permanent improvements made to increase value.
(2) restoring property or making good exhaustion for which an allowance is
or has been made.
*Goal: match expenses with income which expenses produce. Assets which will
produce income for more than the current year will be capitalized.
1. Capital expenditures added to basis. ∋∋ 263, 1016(a)(1).
2. If something is a recurring expense or can't be allocated to a
particular asset, it is a deduction that year.
3. There is bias towards capitalization: if expense can easily be allocate to a
specific asset, capitalize.
4. Examples (*see also 1.263(a)-2)
a. Encyclopedia Britannica - Pre-made reference book purchase was
a capital asset b/c easy to value.
b. Midland Empire - Leaky basement useful until oil refinery moved
in next door. Basement repairs - deductible. (Compulsion)
c. replacements or plan of refurbishment (capitalized) vs. incidental
repairs (not capitalized) (For close calls, ask whether change is
big enough to justify admin. expense of capitalizing)
26

27. d. painting house because generally needed (not capital expense) vs.
painting to add value to sell (capital expense)
e. advertising expenses considered current expenses
5. For businesses, the question is an earlier tax benefit (deduction) vs. a
later tax benefit (capitalization), so argue for deduction.
6. For individuals, current personal expenses not generally deductible
(no tax benefit), so argue for capitalization (later tax benefit).
C. BUSINESS DEDUCTIONS
1. ORDINARY AND NECESSARY BUSINESS EXPENSES
a. § 162(a): business expenses deduction if:
(1) "ordinary" [reasonable business person would incur
the expense]
(2) "necessary"
(3) paid/incurred in carrying on trade or business
including:
-rble. compensation/salaries (limiting: must be rble.)
-travel expenses
-rents
*SEE 1.162-1 for examples*
(2) § 212: deduction for individuals' for ordinary and necessary
expenses for the production or collection of income (as opposed
to personal consumption/use).
(3) Both are deductions unless they are capitalized and are excluded
under § 263.
* (4) Questions to ask:
* (a) Is the expense closely connected with business that
reasonable business person would pay? (OBJECTIVE
-look to industry)
i) No - not deductible
ii) Yes - keep going
* (b) Habitual or customary?
i) Yes - deductible
ii) No - keep going
* (c) Reasonably anticipated?
i) Yes - deductible
ii) No - Not deductible (Gillian - nutty artist on plane)
(5) Some deductions are limited by POLICY - but ONLY the policy
concerns listed in § 162:
162(c): illegal bribes, kickbacks, other illegal payments
162(f): fines and penalties
162(d): treble damage payments under the antitrust laws
(technically made to government, but the court
extended this a little in Stephens when prevented
deduction when payment was court ordered and
made to a third party)
(6) When the TP is NOT in a trade or business (earning money
illegally), § 165 allows "losses" instead of expenses. Stephens
tells us that the limited Policy reasons apply only to § 162 - so any
27

28. policy argument can be made to prevent a loss/deduction under
§ 165.
2. DEPRECIATION AND AMORTIZATION
*business, trade, investment assets which wear out or become obsolete
(1) A tangible asset is depreciated
(2) An intangible asset is amortized on a straight-line basis
(3) When you take a depreciation or amortization deduction, you also
adjust the basis of the asset the same amount.
(4) §§ 167 and 168 - all that is important to know is:
(a) Depreciation method
i) Accelerated (NOT on exam - just know it results in
more depreciation earlier)
ii) Straight line
(b) Recovery period (based on type of property, not on useful
life)
i) 3, 5, 7, 10, 20, 27 1/2, 39 years
ii) Class life
iii) KNOW FOR SURE ON THE EXAM
a) RESIDENTIAL RENTAL PROP - 27 1/2
b) NON-RESIDENTIAL REAL PROP - 39
(c) Convention used
(d) Assume no salvage value
(5) Assets are considered purchased and placed in service midway
through the year (July 1) (some exceptions)
(6) IMPROVEMENTS/ADDITIONS: § 168(i)(6)
(a) depreciate the improvement same length period set for the
asset improved. (i.e. porch on house is depreciated at 27.5
years based on period for house).
(b) begins the later of time when improvement/addition is
placed in service and time when asset placed in service
(c) Two schedules will then be going
i) one for the house
ii) one for the porch
(d) When the house is sold - the bases of the porch and the
house will be added together to determine the gain or loss.
(is this an allocation problem???)
(7) LAND IS NOT DEPRECIABLE b/c it has an indefinite useful
life!!!
3. RENT: Substance over Form Doctrine
28

29. (1) Rent is normally a business deduction.
(2) But if rent is just being used to "cover up" the sale of an asset,
gov't can look at the substance of the transaction and disregard the
form.
(3) If rent is really a sale - the substance is that the asset should be
capitalized.
(4) Starr's Estate - sprinkler system; factory owner tried to treat like
rental agreement.
(a) Substance - Sale of an asset:
(i) Lease silent re: what would happen at end of term
(ii) After 5 yrs., "rent" simply equaled cost of
inspection
(iii) Worth nothing to manufacturer to remove the
system
(iv) Total cost over 5 yrs. = cost to purchase on
installment basis
(v) Manuf. treated like sale
i) Seller/Lessor - ordinary income
ii) Buyer/Lessee - Capitalized asset and depreciation
deductions/reduction in basis
(b) Form - Lease of the system
i) Seller/Lessor - Ordinary income
ii) Buyer/Lessee - Business expense immediately
deductible
(5) Whenever arguing for the taxpayer - if you can make it seem like
there is a REASON for the deal to be done the way it was (other
than to sham the gov't) - then the gov’t is more likely to respect the
form.
4. LOSSES: § 165:
a. Deduction for business loss sustained during the year and not
compensated for by insurance
("sustained": closed transaction; ex: no outstanding ins. claim.)
b. Deduction is lower of FMV or basis [exception: for gifts to
charities, if TP has depreciated property, deducts FMV, not basis]
29

30. D. PERSONAL DEDUCTIONS: Personal expenses are GENERALLY NOT
DEDUCTIBLE. § 262(a). Would encourage needless consumption. But SOME
are specifically allowed as deductible.
1. Personal Exemption and Standard Deduction: intended to take into
acct. the necessary expenses everyone incurs to produce income
2. Itemized deductions: (reduced as income rises)
a. Home mortgage interest. § 163(h)
b. Charitable contributions. § 170
c. Real property taxes: § 164
d. State income taxes
e. Extraordinary medical expenses. § 213
f. Casualty losses
3. LOSSES: § 165(c):
a. Individuals can deduct only for:
(1) losses in trade or business
(2) losses in investment
(3) casualty and theft losses
b. Deduction is lower of FMV (immediately before casualty/theft) or
basis [exception for gifts to charities; if TP has depreciated
property, deducts FMV -- not basis]
c. CASUALTY LOSSES: Given as deductions when the TP suffers
a hardship/loss of personal use property.
(1) Requirements
(a) Sudden:
i) Can’t be slow deterioration (e.g., termites).
ii) Usually same determination made by ins.
co.
(b) Not willful
i) Blackmun - H found W having party and
burned clothes & house - NO casualty loss
(c) Unexpected risk of owning damaged/destroyed
prop
i) Dyer - cat broke vase; expected risk of pet
(consumption expense) - NOT casualty loss
(2) Limits
(a) § 165(h)
i) 1st $100 of ea. casualty not deductible.
Amounts over $100 are added; then
ii) Offset by any casualty gains; then if
iii) More than 10% of the AGI of the individual
(GI - business expenses), deductible.
(b) In determining the loss you must consider any
personal consumption losses already in the
property.
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31. (3) Examples:
(a) Your car = casualty loss. Basis 10,000, FMV
3,000.
i) The casualty loss is $3000
ii) Less the $100 minimum requirement
iii) May deduct $2,900 if AGI < 29,000.
(casualty loss must be > 10% of AGI).
(b) Need to connect non-recognition of involuntary
consumption gains. § 1033 & § 165(h) (this sect.).
E. MIXED PERSONAL & BUSINESS EXPENSES: § 183 - Personal expenses
are NOT deductible, so are problems when expense is both business & personal.
1. TRAVEL AND ENTERTAINMENT
a. § 162 (1st hurdle): allows deductions for travel (incl. rble. amts.
for meals & lodging) while away from home if closely connected
with trade or business
b. § 274 (2d hurdle): DISALLOWS some expenses:
(ER/self-employed denied deduction; EE might have income)
i. ENTERTAINMENT OR RECREATION expenses not
DIRECTLY related to trade or business OR
ASSOCIATED WITH AND DIRECTLY PRECEDING
OR FOLLOWING a substantial, bona fide business
discussion (Danville: Superbowl weekend; no deduction)
*test: ER's primary purpose of trip must be business (if
client willing to pay, almost conclusively business purpose)
ii. Substantiation required: § 274(d) (Levine: at-home
entertainment not deductible b/c no records):
(A) Amount
(B) Time/place
(C) Business purpose
(D) business relationship of person being entertained
iii. 274(b): Ltd. $25 business gift (except promo. materials)
iv. 274(n)(1): limits meals and entertainment deduction to
ONLY 50%. (But NOT lodging)
v. 274(n)(3): cost of spouse travelling with EE is not
deductible unless spouse is EE too.
c. Example.: business buys season tickets; assume closely related to
it.
i. Business gets a deduction - but only 50% b/c entertainment
ii. If EE occasionally gets to use tickets - NO GI because de
minimus fringe benefit. § 132(6)(c)(1).
iii. Do clients who use them don’t have GI. Reg. 1.132-1(b)
(4): One who receives de minimus fringe benefit is an
employee.
d. If ER claims deductions, recipient of benefit should include it in
gross income (but, if for business, will have deduction under 212).
2. COMMUTING EXPENSES
a. Generally - these are personal expenses and are NOT deductible.
b. Travelling salesperson driving from work to first call MAY be
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32. able to deduct (Split of authority)
III. SPLITTING OF INCOME: WHO HAS INCOME?
A. General: TPs try to shift the tax from a higher bracket to a lower tax bracket
Starr's Estate; family members; transactional tax planning
B. INCOME FROM SERVICES - taxed to the person who EARNED the income.
(Lucas v. Earl - H contracted with W for 1/2 of his wages - they were taxed
together on ALL the income). This protects the progressive rate system
C. APPRECIATED ASSETS - When GIVEN - the DE takes the donor's basis (for
gain) - so gain is preserved in the basis - this SHIFTS the incidence of tax to DE.
D. SEPARATION AND DIVORCE: § 1041
1. PROPERTY TRANSFERS (divisions of marital property): No G/L on
transfer between spouses during marriage or incident to divorce (related to
or w/in one year)
a. Treated like a GIFT, BUT special loss rule does NOT apply: DE
TAKES DR'S BASIS. §§ 1015(e), 1041(b)
b. Inapplicable to PRE-MARRIAGE. PLANNING: recognize loss
pre-marriage, transfer appreciated property post-marriage
2. CASH: ALIMONY AND SUPPORT PAYMENTS (future income):
a. ALIMONY
(A) Generally is income to payee. § 71
(B) Generally is deduction to payor. § 215
b. Requirements to be Alimony, (must be):
(A) Payment in cash (to or on behalf of ex-spouse)
(B) Pursuant to separation or divorce decree/agreement
(C) Decree cannot specify that it is a non-deductible payment
(i.e., can't elect to treat alimony as support)
(D) Payee/payor cannot be members of same household
(E) Payment can’t be for support of minor children (i.e., not
tied to child's circumstances)
(F) Can’t be a substitute for property settlement (agreement or
decree must specifically state no liability to continue
payments after payee's death)
(G) No excessive frontloading - where payor pays a LOT in
first 2 yrs. and gets big deductions - then pays little in later
yrs.
(1) Bad for payee b/c HIGH income in first 2 years and
no deductions
(2) So in 3rd year, payee gets deduction and payor
must include some portion of payments in gross
income.
c. § 682: allows payor to create trust which pays & shifts income to
payee even if payment. Wouldn’t otherwise qualify as alimony.
d. Alimony allows high bracket TP to shift income to low bracket TP
d. SUPPORT payments (if not alimony)
(a) Are not deductible by payor
(b) Are NOT includable in GI of payee
32

33. IV. CAPITAL GAINS AND LOSSES: WHAT KIND OF INCOME IS IT?
*Long Term Capital Gain: poss. favorable tax treatment (lower of reg. rate & 28%)
*Short Term Capital Gain: ordinary income: higher tax rate
*Ordinary loss: no limitations
*Long Term Capital Loss, Short Term Capital Loss: only offset ordinary income up
to $3,000 each year
A. POLICY
1. LTCG are treated favorably because gov’t does not want to push TP into a
higher bracket just b/c they sold an asset
2. Offsets the double taxation of corporations
3. Encourages re-investment at better rates, b/c cashing in old investments
won't be a huge tax hit.
4. Helps new business
5. Good politics
B. WHAT ARE CAPITAL GAINS
1. § 1221: All property held by a taxpayer is a capital asset EXCEPT:
a. Property held primarily for sale to customers in the ordinary
course of trade or business
b. Depreciable or real property used in trade or business
*[BUT might be 1231 assets]
c. Intellectual property
d. Accts./notes receivable acquired in the ordinary course of trade or
business for services rendered or from sale of property
2. Long term is an asset held for > one year.
3. Short term is an asset held for < or = one year.
4. Capital G/L comes from:
a. Sale or exchange (transfer of materially different properties) of
b. A capital asset or 1231 assets. (generally recognized at sale or
exchange of asset)
i. Involuntary conversions ARE sales or exchanges.
§ 1231(b)(3)
ii. Retirement of bonds is treated as sale or exchange. (This is
where the bond earned or lost money, NOT just repayment
of principal (no income or loss).)
5. Generally recurring payments are NOT capital gains:
a. Rent
b. Dividends
c. Wages
6. BUT if the recurring payment is an INSTALLMENT SALE, it may be a
capital gain or loss.
7. If property seems like both, do NOT allocate basis. Find the primary
purpose of the asset.
*8. Debate is usually over whether prop. is held for investment or sale in the
ordinary course of trade or business
33

34. Ex: Individual buying & selling securities for own acct. only; wanted
ordinary loss treatment (no limitations); H: capital loss because
own acct. and his work did not affect the value of the stock.
C. WHAT DO YOU DO WITH THEM? *see HO
D. 1231 Assets *see HO
E. BIG PICTURE - BASICALLY There are 3 kinds of assets
a. Capital assets
(1) Capital gain
(2) Capital loss
b. § 1221 (2) assets - (used in trade or business and held for less than
one year)
(1) Ordinary gain
(2) Ordinary loss
c. ∋1231 assets - used in trade or business and held for more than one
year
(1) Capital gain
(2) Ordinary loss
34