Income Tax Outline1. Tax Rates/General Overview

A. Code§ 1 (a-f): Income tax rates§ 1(g): Unearned income of minor child taxed at parent’s rate§1(h): Capital gains (28%)§11 (a-b): Corporate Income TaxB. Taxable Income = Gross income §61 - deductions §62C. Progressive System:

(1) Allocates financial burden of running gov’t(2) Belief in declining marginal utility of money ($1000 worth more to poor man than

rich man)(3) Rate schedules (§1) avoids penalizing taxpayer for making marginally more money

-- would create disincentive to make more money (although this already exists to certain extent with higher rates)

(4) Deduction phase-out: Above a certain income, deductions are phased out.D. Marriage Benefit/Penalty

Case Married Tax Single TaxMarried, 1 wage earner(50 K Total)

$9203 $11407

Married 25 K husband25 K wife(50 K Total)

$9203 $4127+$4127 $8254

Married, 40 K husband10 K wife(50 K Total)

$9203 $8327 (40K)+$1500 (10K) $9827

Can’t get rid of marriage penalty by allowing each spouse to file separately if more advantageous b/c then could allocate interest income (really husband’s) to lower-bracket wife.

2. Fringe Benefits: RealizationA. Code§61(1): Gross Income includes fringe benefits§§1.61-1(a): Gross income includes services, meals, accomodations, stock, etc.1.61-2(a): Gross income includes bonuses, retirement pay, pensions, etc.1.61-2(d) : Compensation Other Than Cash: Given property or services in exchange

for services rendered by taxpayer, income = FMV of property/services received.Loopholes: Company cars, health plans, etc.B. Cases

1. Old Colony: Taxes paid = income. When a company pays income taxes for employee, this counts as additional income, b/c employee is receiving benefit of the payment (even though he never actually received the extra money).

2. Ward/Dreshcer Life insurance/annuity for employee is a taxable benefit. Value of annuity/life insurance policy is taxable on the day the policy goes into effect, even if employee doesn’t necessarily have access to policy until years later-- essentially not

allowing taxpayers to use cash method for annuity policies. (Although if taxpayer doesn’t have access to policy he is only liable for present value of future interest).

C. Accounting Methods1. Cash Method: Present holdings -- income when received, deductible when paid.2. Accrual Method: Obligations -- income when owed to taxpayer, deductible when

debt is incurred.a. Liquidity Problem: May owe more taxes than you can pay with actual cash on

hand.b. Non-payment: You pay taxes based on expected future gains, but then if those

are never paid you lose twice (pay $10 tax on $50 owed, then $50 is never paid, you lose $60)

3. FV = PV (1+r)n r = interest rate on money invested;n = number of years invested

D. Tax-Free Fringe Benefit = Tax LoopholeWS #3: Taxpayer is taxed on 200 income; but if he values certain tax-free fringes (company car, health plan, lunches, etc) at 50, then can be paid 150 and come out ahead:

Income: 200 150Fringe Value: 0 50-(Tax @ 40%) (80) (60)Net: 120 140

But we don’t really want to tax these fringes as equal to income b/c their actual value to the employee is impossible to measure.

3/4. Fringe Benefits: Valuation ProblemsA. Code: §119: Meals or lodging not taxable if 3 conditions:

(1) Must be actually provided, not just voucher(2) Provided on business premises(3) Provided for convenience of employer (food)

or condition of employment (lodging) §119(a): Meals/lodging for employee, spouse, dependents

§119(a)(4): Meals furnished on business premises by employer are deductible if served to more than half of all employees.

§132 Tax-Free Fringes:(b) No-additional cost service (must be offered for sale to customers in ordinary line of business)(c) Qualified employee discount (selling property at cost or services at 20%)(d) Working condition fringe(e) de minimis fringe(f) qualified transportation fringe(g) qualified moving expense(h) Employees = retired/disabled employees, spouses, dependents

(h)(3) also parents for airlines§§1.132-1(f): §132 does not apply where it conflicts with another § of Code.§§1.132-3(a)(2): Exemption for employee discount for property does not apply to

investment properties (stock, commercial real estate, etc)§132(e): De minimis fringe: so small as to make accounting impracticable

§132(e)(2): Eating facilities de minimis if on business premises and eating facilities breaks even or makes profit.

§132(j): No discrimination in favor of highly-compensated employeesB. Cases:

1. Benaglia Necessary food/lodging not taxable. Food and lodging paid by employer which are required for employer’s duties and primarily for need/convenience of employer is not taxable.

2. Kowalski Lunch money/vouchers provided to employees is taxable. NJ provided State troopers with $5 for lunch every day, considered the whole state business premises

a. Hidden Income: this was hidden cash income -- not spending all $5 on lunch.b. FMV: Even if used all $5, the benefit to employees was probably $5, not less, so

don’t exclude as where food provided by employer and employee has less choice.3. Firm lunches: Would fail §119 b/c not on premises, but OK b/c §132 de minimis fringe.4. Non-discrimination: Cannot give

C. Policy: (3 options with valuing fringe):1. Over-taxation: Tax at FMV (but employee probably doesn’t value the lunch, lodging, etc at

FMV)2. Exclusion: Don’t tax at all -- but the fringes are worth something to taxpayer3. % of FMV: This taxes the taxpayer on the benefit w/o over-taxation -- but impossible to

figure out a fair rate

5. Income vs. Capital RecoveryA. Code§61(a)(3): Gross income = gains derived from dealings in property§1001(a): Gain/loss = amount realized - adjusted basis§1001(b): Amount realized = money received from sale + property received from sale§1012: Basis = cost§1016: Adjustments to Basis§1016(a): Basis reduced by amount for which deduction taken for expenses, losses,

exhaustion, wear and tear, etc.§1016(b) Basis reduction in substituted basisB. In a transaction where property interest is divested, this is capital recovery;

where property interest is not divested, it is income.1. Easement = capital recovery Inaja Land Co. Fishing co. diverted water,

damaging T’s land, paid T for permanent easement over land -- this is capital recovery. T compensated for permanent loss of property interest (easement) Irrelevant that the amount paid for the easement was greater than the actual damage, b/c T has lost the property interest forever.

2. Lump payment from lessee to taxpayer for breaking lease = income Hort v. Commissioner Taxpayer received up-front lump payment from lessee when lessee broke lease, to compensate taxpayer for losses from future rents; But taxpayer kept property (rental building), so not a capital recovery.

C. Basis Allocation: Irwin v. Gavitt $1000 bond made ten $100 interest payments over 10 years, then returned principal of $1000. Bondholder assigned interest to A and principal to B; B, remainderman/principal holder, gets all the basis; A gets no basis.

D. Policy: Increases in property value not taxable until sold.1. Valuation: Difficult to value; Until the actual sale, the increase is speculative.2. Liquidity: Taxpayer may not have cash on hand to pay taxes on increase.

6. GiftsA. Code§ 102: Gift, devise, inheritance is not income§102(c): Gifts from employers to employees IS INCOME.§274(b): Donor cannot deduct cost of giving gift.§274(j): Limitations on deductions for employee achievement awards§1014: Basis of property acquired from decedent = FMV at decedent’s death§1014(b): Acquired from decedent = either through will/bequest/inheritance, or

trust set up during decedent’s lifetime to pay income to decedent with remainder to donee, if always revocable in decedent’s lifetime.

§1015: Basis of property acquired through living gift or transfer = donor’s basis.B. Loss: Under §1015, where donee sells property for amount lower than FMV at transfer,

can use FMV to calculate loss; but if sells for amount higher than FMV no loss.(SEE EX. 2 and EX. 3 on Problem Set 3)

C. Cases1. Glenshaw Glass Punitive Damages from lawsuits are taxable income. (But

regular, compensatory damages are not income)2. Duberstein Gifts given in business context generally not deductible.3. Taft v. Bowers Donee in living gift must pay taxes on entire gain. A buys stock

at 10, rises to 50, gives to B, rises to 100, B sells -- B must pay taxes on 90 gain.D. Policy

1. Employee gift arbitrage: If employee gifts are tax free and deductible, and employers have different tax rates than employees, can take advantage of tax system to transfer more to employee at same cost to employer as salary (see handout 6)

2. §1014 Valuation: Often no way to know how much dead person paid for property, so easier to just do FMV at death.

3. §1014 Loophole: But this creates huge loophole b/c gain during dead person’s lifetime is never taxed.

7. Discharge of IndebtednessA. Code§61(a)(12): Discharge of indebtedness = income§108(a)(1): Discharge of indebtedness is not income if

(A) in Title 11 bankruptcy case(B) taxpayer is insolvent

§108(d): Indebtedness = taxpayer is personally liable for debt or holds property subject to debt.

B. Notes1. Loan proceeds are not income and loan repayments are not deductible.2. Gift vs. discharge of indebtedness

(a) X borrows $10,000 from parents; out of love, parents forgive the loan -- this is a gift.

(b) X borrows $10,000 from bank, parents repay loan -- also gift.(c) X borrows $10,000 from bank at 5% interest; interest rates go up so bank

settles debt for $7,000 (PV of debt at current, higher rates); $3000 is discharge of indebtedness.

C. Cases

1. Kirby Company issues bonds, then repurchases them for $138,000 discount -- this is discharge of indebtedness

2. Zarin Z ran up $3 million gambling debts to casino, settled in court for $500,000; Not discharge of indebtedness b/c:(1) Gambling debt was illegal, therefore Z had no legal liability under §108(d)(2) Debt was disputed and settlement served only to fix the amount of debt did

not discharge anything.

8. Transfer of Property Subject to DebtA. Code§§1.001-2: Amount realized from sale includes debt assumed by buyer if recourse

loan. §§1.001-1(e): Transfers Part Sale/part gift: Donor has gain to the extent that sale price is

above basis; but no loss can be claimed from this transaction.§§1.1015-4: Transfers Part Sale/part gift: Donee has basis of either amount paid or donor’s

basis, whichever is greater.B. Recourse vs. Non-recourse loan

1. General: In non-recourse, bank/lender can only go after the property, nothing else, so investor can just walk away from the property and be fine; in non-recourse, it is the creditor, not the debtor who suffers if property value declines.

2. Illustration: X takes $100,000 loan to buy house; interest rates increase so PV of $100,000 = 90,000; X sells house to Y for $10,000 and assumption of loan;a. Recourse: Separate gains from property value and gains from discharge;

here the 10,000 was gain from discharge, not increase in property value, so $10,000 is taxable as income.

b. Non-recourse: Don’t separate gains from property and gains from assumption of loan; so $10,000 is treated as capital gain (gain treated as if it came from increase in property value).

3. So, in non-recourse debt, loan and property transaction tend to meld together -- this is traditional in commercial real estate.

4. Regardless of type of loan, basis remains the purchase price (including loans) for the property.

C. Cases1. Woodsam Basis is not increased when owner borrows additional money on the land

(second mortgage)2. Crane , Taxpayer who sold property subject to non-recourse mortgage must include

unpaid balance of mortgage in amount realized from sale.3. Tufts If non-recourse loans used to buy property and taxpayer takes deductions from

property basis, then non-recourse loans must be included in amount realized at sale of property.

D. Rule doesn’t matter for non-recourse loans, as long as same rule going in and coming out, to avoid scenario p. 251, where T buys and sells building for small up-front cash and takes big non-recourse loan, then claims big deductions for depreciation.

E. Punchline: Non-recourse loans treated as recourse loan for basis purposes on sale of property; but treated as non-recourse for purposes of capital gains vs. income

9. Realization (stock dividends)A. Code

§61(a)(7): Income from dividends is taxable.§305(b)(1): Stock dividend taxable if shareholder had option to take cash or other property;

not taxable if only a stock split.§1001(a): Gain/loss = amount realized - adjusted basis§1001(b): Amount realized = money received from sale + property received from sale

Realization: Gain or loss might be taxable/deductible.Recognition: Gain or loss is taxable/deductible.B. Cases

1. Stock split is not taxable: Eisener v. Macomber A stock dividend paid in cash is income; but paid in more company stock (stock split) is not income, b/c stockholder has received no additional value -- a stock does not entitle stockholder to any additional assets, only the same share of company profits.(a) No wealth increase b/c total investment remains the same(b) 16th Amend. allows tax only on income

2. Materially different: Taxpayer recognizes gain or loss from transaction only if exchange of materially different property (or prop for cash) Cottage Savings Association Bank exchanged S+L mortgages, reporting a loss. Although mortgages were “economic substitutes”, they were different loans to different people, so are materially different, therefore bank can deduct loss for taxes.

10. Nonrecognition Rules A. Code§ 109: Improvements to property by lessee are not income for lessor.§1019: Lessor can’t use improvements by lessee to increase basis.§1031(a)(1): Nonrecognition for in-kind exchanges of property held for productive use

in trade, business, or investment (2): Exceptions:

(A) stock in trade (inventory)(B) stocks, bonds, etc(C) other securities/evidence of indebtedness(D) interests in partnership(E) certificates of trust

§1031(b): Like-kind exchange plus boot, taxpayer recognizes lower of either value of boot or amount of gain realized.

§1031(c): Losses with boot are not recognized.B. Cases

1. Trade of gold for silver is taxable b/c not like-kind exchange. Rev. Ruling 822. Jordan Marsh A sells prop to B for a loss, then B leases back to A. This is not a like-

kind conveyance, it is a sale, therefore A’s loss from the sale is deductible.C. § 1031 Requirements

1. Trade/business/investment: Cornfield for vacation property: A trades cornfield for B vacation home; A plans to use vacation home for investment, so gets in-kind §1031 treatment; doesn’t matter what B plans b/c original property wasn’t trade/bus/invest. Can trade like-kind property used for trade for like-kind prop. used for investment; OK as long as one of these three.

2. Like-kind: Must be vehicle for vehicle, real property for real property;Farmland for apartment OK; Truck for car OK; Farmland for car not OK.

3. Statutory Exclusions: Can’t trade different sex animals.D. Basis: (See Handout 10)

§1031(a) Exchange: Taxpayers keep old basisPre-trade: A has X basis 20, FMV 100; B has Y basis 60, FMV 100;Post-trade: A has Y, basis 20; B has X, basis 60.§1031(b) Exchange: Boot paid becomes part of new basis; Boot received (or pre-exchange amount realized, if less than boot) is taxable income.Pre-trade: A has X basis 20, FMV 100; B has Y basis 60, FMV 150; Trade plus a give B $50;Post-trade: A has Y, basis 70; FMV 150; B has X, basis 60, FMV 100; B recognizes 50 taxable gain.(Note: If B had original basis of 120, then post-trade B would recognize 30 taxable gain)

11. Imputed IncomeA. Home ownership: The rent that taxpayer saves by owning home is imputed income and

not taxed: A and B, each paying $8,000 in annual rent, each inherit $100,000; A invests in T-bills @ 8%, B buys house. A earns $8,000 interest, pays tax; B saves $8,000 per year on rent but pays no tax -- B’s rental saving is imputed income.

B. Services: Services performed for yourself (housework, painting house, etc) are imputed income, not taxed.

C. Increases Housing Prices: Keeps housing and land prices high; b/c return on $100,000 investment on house is $8,000; to get $8,000 return on T-Bills would have to put up $120,000; so housing price is higher than would be w/o tax break. -- if Congress took away the subsidy, prices would fall and current homeowners would lose money, so political pressure to keep subsidy.

D. Discourages wife working: A couple works for $20,000 and pays $20,000 for cleaning service; B couple wife stays home. Although economically equal, B comes out ahead b/c A income is taxed, B imputed is not. So discourages wife from working

12. Tax-Free Municipal BondsA. Code§103: Interest on state and local bonds is not taxable (except arbitrage and private

activity bonds)§265: No deduction for interest used to purchased tax-exempt bonds.B. Effects

1. Return on state/local bonds is lower than on taxable bonds2. Shift from federal to state/local treasury (often not a complete shift b/c taxpayer can

exploit difference between rate of return and marginal tax rates to keep some of the benefit for themselves)

C. Limitations1. Arbitrage bonds: City sells bonds at 6%, buys T-bills paying 10%; City can finance its

whole budget this way, city/states pay no federal taxes. This is banned by §103(b)2. Industrial/Small issues bonds: City issues bonds to finance businesses in it s

jurisdictions; no recourse against city (or company) if venture fails but bond retains tax-exempt status (essentially subsidy for companies); This was limited by Congress.

3. Progressivity: These bonds attractive to high-bracket earners: $1,000 invested in Municipal bond (6.5%) vs. T-Bill (10%); After taxes:

A 40% bracket: Municipal = $65; T-Bill $60 (100 - 40)

B 30% bracket: Municipal = $65; T-Bill $70 (100-30)When cities want to raise more money, have to raise interest rate to above 7% to attract lower-bracket investors, but this benefits high-bracket investors also, undercuts progressivity. Solution was Alternative Minimum Tax, includes more things (like municipal bonds) but at lower rate.

13./14. Introduction to DeductionsI. Code

Gross Income-- §62 Deductions (Above-the-line: trade/business expenses, alimony, etc)

Adjusted Gross Income -- §63 Deductions (Below-the-line: itemized deductions, subject to §67, §68)

Taxable Income

§62: Trade/business expenses (if taxpayer not performing services as employee); Rents & royalties, alimony, etc. Certain employee services: reimbursed expenses, performing artist, etc. SEE RULES

§67: Miscellaneous itemized (§63) deductions allowed only to the extent they exceed 2% of A.G.I. (Does not include investment interest)

§68 For A.G.I. over $100,000, (§63) deductions reduced by 3% of the excess A.G.I. over $100,000; or 80% of deductions

§162: Trade/business deductions = salaries, travel expenses, rentals and payments. “Ordinary and necessary business expenses”Note: §62 treatment for bar dues/legal periodicals if self-employed lawyer; §63 treatment if associate in law firm.

§165: Losses allowed as deductions if not compensated by insurance; but (d) wagering losses allowed only to the extent of wagering gains.

§212: Individual deductions allowed for production of income if:(1) Production/collection of income(2) Management/maintenance/conservation of property(3) Tax preparer/accountant fees

§262 No deductions for personal, living, or family expenses§274(n): 50% deduction for meals and entertainment business expense (Employees cannot deduct expenses for which they were reimbursed by employer)§280A: Home-office deduction only deductible if part of trade/business

13./14 DeductionsII. Illustrations

A. Investment interest deduction is “net investment”; comes AFTER all other investment-related deductions (after imposition of §67 and §68); But investment interest is not itself subject to §67 and §68. Deducted ONLY from investment gains. (See 163(d) handout); # 18 Tax Shelter

B. Managing investments is not a trade or buisness. Home-Office Deduction: Must be place used for production of income and in a trade or business. Moller Managing investments from home is not a trade or business (taxpayer is not a short-term stock trader); amount of time taxpayer spends managing investment is irrelevant, therefore no home-office deduction.

Note: home/office deduction can only come under §62, so no deduction at all; but other expenses -- investment magazines, etc OK b/c “production of income” even though not trade/business

C. Reimbursal1. Firm associate reimbursed for expenses: no deduction2. Firm associate not reimbursed for expenses: deduction, but under §633. Travel expenses: hotel, airplane = §162; food/entertainment = §274

D. Business deduction must arise in connection with profit-seeking activities: Gilmore G hired lawyer in divorce lawsuit, G deducted legal expenses under “conservation of property” b/c wife suing to get G’s business property. This is not deductible b/c expense arises from personal matter, not the profit-seeking activity.

E. “Ordinary and necessary” 1. Gilliam Psychotic outburst not ordinary and necessary: G travelling on business, has

psychotic reaction to medication and attacks passenger; sued in civil and criminal court. G’s legal fees are not deductible b/c not ordinary and necessary to his business (although the cost of the flight itself is deductible)

2. Dancer legal fees from traffic accident while driving on business trip is deductible.3. Bribes or fines paid are not deductible (§162c, §162f)

15. Business/Personal BorderlineA. Code§183: Activities not engaged in for profit: Deduction allowed only to the extent of

gains from the activity. (Note: these are §63 deductions)§183(d): Activity profitable for 3 out of last 5 years is presumed to be for-profit.§274(a): No deduction for entertainment expenses unless directly related to,

immediately preceding or following substantial and bona fide business discussion.(a)(3): No deduction for club dues

§274(b) No deduction for gifts over $25§274(d) Must have adequate record of expenses§§1.274-2(f)(2): Can’t take deduction for meetings which are primarily for social or non-

business purpose. (But decided on case-by-case basis.)B. Cases

1. Future Expectation of profit = deductible: Nickerson Taxpayers purchased dilapidated farm, worked on weekends to improve -- taxpayers can deduct losses from activity b/c they hope/plan to eventually run the farm for a profit.

2. Office decorations not deductible Henderson3. Daily business lunches: Moss Lawyers at firm meet for lunch every day near

courthouse to discuss cases; although this was convenient, not a necessary business expense, so not deductible.

C. Policy: 1. §183: Separate businesses from hobbies

a. Profit is a proxy, but rule is inclusive, not exclusive.b. Expectatioin: Amazon.com, which has lost money last 5 years, is for-profit b/c

owners expect to make profit; expectation is totally subjective.2. §274: Clarify ordinary and necessary to explicitly disallow extravagant items

--luxury skyboxes, etc.

16. Capital Recovery A. Code

§195(c)(1)(A): No deduction for start-up expenditures(i) Investigating creation or acquisition of active trade/business(ii) Creating active trade/business(iii) Any for-profit activity before beginning of active trade/business

§197 Amortization of goodwill and other intangibles§263 No deduction for capital expenditures (new building or permanent improvements

increasing value of property) See land development exceptions.§263A Assets purchased or produced in-house are both capital, not deductible

business expense.B. Cases

1. Producing multiple assets for long-term gain is deductible b/c business expense, but one-time asset is capital expenditure.a. (Dad, Julia Child) Authors of books can deduct expenses immediately, b/c

producing multiple assets yielding long-term income is deductible as “ordinary and necessary business expense” Faura

b. Encyclopedia Britannica Publisher made one-time deal to farm out production of an asset, this is not recurring, so is capital expenditure.

2. Purchaser cannot deduct seller’s business expenses. Rev. Ruling 85-82: Farmer who buys farm in 1993 may not deduct cost of purchasing seeds in 1992 -- this was born buy seller, and is included in farmer’s basis (capital) when he purchased the farm.

3. Repair and maintenance (which does not increase prop. value) is deductible business expense, not capitala. Midland Empire Facilities threatened by oil nuisance, built wall to protect. This

is to keep company in operating condition, not improve or extend life of facility, so it is ordinary and necessary business expense, not capital expenditure.

b. Rev. Ruling 94-38 T purchased land and polluted it with industrial waste; paid to clean it up and install clean-up measures. This did not increase the value of land from before T polluted, so provides no benefits therefore is business expense, not capital.

4. Start-up costs which increase property value are capital Mt. Morris Drive-in: Movie company knowingly buys soggy land, installs drainage system; this is start-up cost, so capital, not business expense, no deduction. (New builder who built purchased land in Midland knowing of oil and built wall would be capital start-up)

C. Policy1. Capital expenditure not deductible b/c taxpayer is not poorer in any sense, tax code

wants to recognize real changes in wealth (as income from gain or deduction from loss) not mere changes in the form of existing wealth (trading cash for stock)

17. Capital Depreciation§ 1016: If you take a deduction for depreciation, you must reduce your basis by that

amount.Note: To deduct for depreciation, must be wasting asset -- land itself is not depreciable.

A. Depreciation Methods: (WS 14) Given $100 asset with useful life of 5 years: 1. Straight-line method: Deduction of $20/year for 5 years2. Double-declining balance method: Deduction of double the straight-line percentage of

remaining basis. Note: switch-over to straight-line when this would give larger deduction

-- Year 1: 100 basis, 40 deduction. Year 2: 60 basis, 24 deduction (60 X 20% X 2); etc.

3. Double-declining plus shortened life method: Double-declining but over 3 years, so Year 1: 100 basis, 66 deduction. Year 2: 34 basis, 22 deduction. Year 3: 12 basis, all deducted (switch over to straight-line)

B. Expensing Methods (WS 15) Purchase boat in year 1, sell for loss in year 3.1. Expensing Method: Deduct the entire cost of acquiring the asset in the year of

acquisition -- this leads to low taxes initially, more taxes later b/c no deduction for depreciation or loss on sale.

2. Realization Method: Deduct the loss from reduction in value of the boat in the year of sale (year 3) -- this leads to tax break at the end.

3. Depreciation over 3 year period -- same taxes every year, no deduction for loss on sale. 4. Current system: accelerated depreciation

C. Consumption Tax: 1. Consumption tax = income tax with deduction for savings/investment2. Expensing method allows taxpayer to invest lower amount and get same $$ return as

taxpayer under depreciation method. This is essentially consumption tax, and has economic equivalent to not taxing profits under depreciation tax;

D. Depreciation and Capital Gains:§1245: Gain up to the amount of depreciation is treated as income, not capital gain -- applies to business property, NOT real estate.1. Hypo: T buys business property for 100, depreciates to 88 (at 40% tax bracket),

remaining basis 12. Sells for 120. a. 88 is ordinary gain, taxed at 40%;b. 20 is capital gain, taxed at 25%c. If we allowed all 108 to be taxed at 25%, then would pay 27 taxes, and would have

deducted 34 from property.2. Tufts Case: Taxpayer purchased for 1.9 million, took 0.5 million depreciation deductions

(at 50%, so 250,000 gain), reducing basis to 1.45 million. Sold for 1.85 million, which at 1.45 basis is 400,000 gain. Taxed at cap gain rate 25% = 100,000. So taxpayer gained 150,000 on a losing venture -- not allowed under §1245 (except this was real estate, not business prop, so OK)

18. Anatomy of a Tax ShelterA. Code§101(a): Life insurance payments from death of insured is not income.§163(a),(d): For individuals (not corporations) Interest paid on debts is deductible, but investment

interest deduction limited to amount of net investment income. (Investment income minus post-deduction investment expenses)

§163(d)(2): Deduction carryover: Interest paid on debts not allowed as deduction can be carried over to next year.

§264(a): No deduction for premiums paid or interest on debt to buy life insurance.§265(a)(2): No deduction for interest used to incur tax-exempt investments.B. Cases

1. Knetch Taxpayer purchased annuity policy, then borrowed off policy; no investment purpose other than to claim deduction for interest paid, so no deduction allowed (at time highest tax rate was 90%, so deduction was like a credit)

2. Sole purpose of investment is tax avoidance: (Circuit split)

a. Fabreeka (1st Cir): Interest deduction OK b/c investors incurred risk of ownership in investment.

b. Goldstein (2nd Cir) No deduction if sole purpose was tax avoidance.C. Investment Interest Deductions (§163(d))

1. Investment interest is deductible only to extent of net investment gain; 2. Net investment gain = Investment income -- non-interest expenses (magazines, advisors, etc);

subject to §67, §683. Ex: $30,000 salary, $10,000 investment income, $1,000 investment advisor, $14,000 investment

interest: a. Deduct $1,000, subject to §67, so $800; $10,000-800=9200 = net investment incomeb. Can deduct 9200 from interest; so $30,000 taxable income; $4,800 interest carryover.

D. Effects of 265 and 163(d)Hypo: Taxpayer borrows $100 at 10%, can invest in stock which rises in value 60% over 6 years, or tax-exempt bond paying 10% a year for 6 years; Income rate is 40%, cap gain 20%.1. Pre-265(2): Normally, would invest in tax-exempt b/c return is tax free.2. Post-265(2):

a. Tax-exempt: Interest paid (10% of 100 = 10 X6) = 60; return = 10 X 6 = 60 After-tax return = 0

b. Stock: Interest paid (10% of 100 = 10 X6 = 60 - 40% deduction) = 36; return is capital gain, so 60 -20% = 60 - 12= 48.After tax-return: 48 - 36 = 12

3. Post -163(d): Can’t deduct interest payments until the stock is cashed in. But, if capital gain treatment then no deduction, so 48 gain and 60 cost; or treat as income and 0 return. So 163(d) discourages borrowing to invest ;

E. Policy1. §265(2): Arbitrage prohibition hurts lower-brackets: Allowing deduction for interest on tax-

exempts would enable lower-bracket taxpayers to take advantage of the tax-exempts. (Similar to mortgage deduction, which allows both low tax bracket through mortgage tax deduction and high tax bracket to who buy house outright to both enjoy imputed income of no rent)

2. Knetch -type situation not allowed b/c borrowing on a life insurance/annuity defeats the purpose of life insurance policy as protection for family in case of death.

19. Responses to Tax SheltersI. Code

§165: Losses allowed as deductions if not compensated by insurance; but (d) wagering losses allowed only to the extent of wagering gains.

NOTE: §465 and §469 APPLY ONLY TO INDIVDUALS, NOT CORPORATIONS§465(a): Deduction from loss limited to amount at risk (Can only deduct up to revenues

from activity + amount at risk)§465(c)(2): Separate activities -- in certain investments (videotapes, oil/gas farm, etc. each

activity is considered separate for loss/gain purposes§469: Passive activity losses deduction limited to passive activity gains. (But, unlike

465, can aggregate passive activity losses, no separate activity restriction§469(b): Carry over: Disallowed loss can be carried over to subsequent years, until gains

or property is disposed of. §469(c): Passive Activity = conduct of any trade/business which taxpayer does not

materially participate in; passive activity includes any rental activity§469(h): Material Participation = regular, continuous, and substantial§469(c)(7): Real estate exception: All loses deductible 469 does not apply to real estate

if 750 hrs/year and more than half of work spent on this)

§469(i): First $25,000 is deductible for rental real estate activity (regardless of hours worked or material participation)

§469(i)(3): Phase-out: Reduced by 50% of amount taxpayer’s A.G.I. exceeds $100,00.

Code Investment Affected Deduction Affected§469 Passive trade/business All§465 Trade, business, investment Excess of “amount at risk”§265 Tax-exempt bonds Interest§264 Insurance products Interest§163(d) Portfolio investments Interest

19. Responses to Tax SheltersII. Illustrations

A. Cases: Lease-back between 2 parties is sham so not deductible; among 3 parties is genuine transaction, so deductible.

1. Franklin Taxpayer purchased property with 10-yr mortgage, re-leased property to seller, rent = mortgage + interest; no money changed hands, at end of 10 years purchaser would owe $1 million on mortgage, could pay or default to buyer. This is an option to buy, not a purchase, so not tax deductible.

2. Lyon Because of local law, bank set up a 3-way transaction between bank, Lyon, and financier to build new building. Although Lyon acted as intermediary, he bore the risk of the building and debt to NY financier, so he can take deductions.

B. §465 “Amount at Risk”1. Ex: Taxpayer invests $50,000 of his own money, gets $400,000 non-recourse loan from

seller/promoter, has $10,000 revenue (rent) from property, $100,000 losses. Can only deduct $50,000 + 10,000 = 60,000; other $40,000 loss carried over. Next year can deduct only $10,000

2. At risk:a. Cashb. Equal to basis of other property which contributes to activityc. Amount borrowed from uninterested party if

(1) recourse loan(2) nonrecourse but property pledged is unrelated(3) special nonrecourse loan for real estate, if pledged by 3rd party (Lyon)

C. §469 Rental Real Estate1. 469(c)(7): All loses deductible if participation requirements met:

(B)(i) more than 50% of taxpayer’s total personal services performed in trades/business for the year spent on real estate where taxpayer materially participates; AND

(B)(ii) taxpayer performs more than 750 hours per year on the real estate.3. 469(i): If above requirements not met, then $25,000 deductible

(But, reduced by 50% of amount that A.G.I. exceeds 100,000)D. WS 9: T works full-time in law firm for 90,000/year. T purchases shopping center for

$1 million; $200 recourse loan; 800 non-recourse loan; $500k recourse loan to improve property; Year 1 50,000 loss; Year 2 150,000 loss. Year 3 building sold for 2 million. No depreciation deductions taken:1. Loss deduction for Years 1 and 2: T works full-time in law firm, so doesn’t meet

469(c) participation requirements, but can still take 25,000 each year (b/c only 90,000 salary), so carry-over of 150,000;

2. Sale: 2 million sale price- 700,000 basis- 150,00 carry-over

1,150,000 taxable --- this is capital gains

21. Charitable DeductionsA. Code§170(a)(1): Charitable contributions are tax-deductible§170(b)(1): List of charities to which contributions are deductible; limited to extent that

aggregate is 50% of taxpayer’s A.G.I. Other groups deductions limited to 30% of A.G.I.

§170(c): Charitable deduction = religious, charitable, scientific, literary, educational§170(d): Carry-over of amount over % limit for succeeding 5 years§170(e): Gift of property that would get capital gain treatment is deductible at FMV; gift

of property subject to ordinary income treatment is deductible at basis.§170(e)(1):Unrelated tangible personal property: If donation of property is item unrelated to

what charity does (art work to Red Cross) then only basis deduction.§170(f)(8): Receipt needed for contributions of $250 or moreTax Reform Act: Independent appraisal required for donations over $5,000B. Cases

1. Donation resulting in substantial benefits/profits to taxpayer is not deductible Ottowas Silica Taxpayer developer donated land to county to build school -- developer knew school construction would increase value of surrounding land, benefiting taxpayer, so no deduction.

2. Institution which violates public policy is not tax-exempt Bob JonesC. PolicyPro ConPeople like it -- much more willing to give to charity than gov’t

Weird people/offensive organizations --

“Direct Democracy” -- more control over where your tax dollars go

Charities can’t distribute money as effectively as gov’t

Keeps gov’t out of charities Need gov’t oversight of charities -- Bob Jones

ReligiousD. Effects of 170(e) Property Donation: Long-term Cap gain vs. Short-term cap gain/Income

(handout 20)1. Cap gain donations have higher foregone bank account, so we give bigger tax savings

than to short-term gain donations, which have lower foregone bank account. $250 FMV, basis $50; 28% cap gain tax

2. Direct donation vs. sale and donation of proceedsa. If short-term gain, same result if taxpayer donates property directly or if taxpayer

sells property and donates to charity.b. But, if long-term gain, code encourages sale and then donation of proceeds.

E. §68 Phase -out: Unlucky high-bracket taxpayer could have up to 80% of charitable deductions phased out.

22. Introduction to Capital Gains

A. Code§1211 Capital Losses:

(a) Corporate: Allowed only to extent of capital gains; No deduction; excess losses carry over for only 3 years

(b) Individual: Allowed to extent of capital gains + $3,000; Remaining losses carry-over forever: Capital losses (short or long term) must be first used to offset capital gains, then can deduct $3,000 if remaining losses, can carry over extra forever.

§1221 Capital Asset does not include:(1) Stock in trade “held primarily for sale to customers” (inventory) (2) Property used in trade/business(3) Copyright held by creator(4) Accounts receivable(5) US gov’t publication received at discount by gov’t employee

§ 1222Short-term capital gain: Held not more than one yearLong-term capital gain: Held more than one year

B. “Held for sale to customers” 1. Customers: Van Strudel T held securities for investment, then sold them for loss at

best price he could -- didn’t care if buyer was a “customer” so not considered inventory -- this is capital gain (taxpayer wanted income loss treatment)

2. Frequent sales and improvements = trade/business, not capital gain. Biedenharn Realty Realty co. purchased land, re-sold it in numerous parcels and made improvements -- this is ordinary income, not capital gains.

“Property”: Disposition of lease (property rights) is different from rights to proceeds FerrerC. Cap gains treatment

1. Old regime: §1(h): If taxpayer has income taxed at higher than 28%, amount of cap gains that would be taxed at higher rate under the tax table, is reduced to 28%.

2. New System: Old system did not help taxpayers in lowest 15% bracket, so new system which is enormously complex.

D. Offsetting Past Gains: Corporation can use current capital losses to offset past capital gains retroactively; an individual cannot.