federal income tax: doctrine, structure, and policy text ... · federal income tax: doctrine,...

FEDERAL INCOME TAX:DOCTRINE, STRUCTURE,AND POLICYTEXT, CASES, PROBLEMS

FOURTH EDITIONJOSEPH M. DODGEStearns, Weaver, Miller, Weissler, Alhadeff, and Sitterson Professor of LawFlorida State University College of Law

J. CLIFTON FLEMING, JR.Ernest L. Wilkinson Chair and Professor of LawJ. Reuben Clark Law School Brigham Young University

ROBERT J. PERONIFondren Foundation Centennial Chair for Faculty Excellenceand Professor of LawUniversity of Texas School of Law

r LexisNexis'

TABLE OF CONTENTSPart One THE FUNDAMENTAL STRUCTURE OF THE FEDERAL

INCOME TAX . 1

Chapter 1 TAXONOMY, HISTORY, AND THE INSTITUTIONALSTRUCTURE OF TAXATION IN THE UNITED STATES . 3

A. TAXES PRIOR TO THE CONSTITUTION 3

B. BRIEF CONSTITUTIONAL HISTORY OF FEDERAL TAXES 4

1. The Framing and Ratification of the Constitution 4

2. From 1789 to the Sixteenth Amendment 6

3. From the Sixteenth Amendment to the Present 9

4. State Taxation under the Constitution 12

Problems and Notes 12

C. INTERNATIONAL TAXATION 14

1. National Taxing Jurisdiction over Income 14

2. Mitigating Double Taxation "... . . . 14

Problem 16

3. Value Added Tax . 16

4. Comparative Tax Burdens 17

D. OTHER FEDERAL TAXES OF NOTE . 17

1. The Payroll Taxes : 17

2. The Federal Wealth Transfer Taxes 20

3. Federal Income Taxation of Entities 20

Note 21

Problems 21

E. FEDERAL TAX LAW DSf THE STRUCTURE OF GOVERNMENT 22

1. Federal Tax Law as Statutory Law : 22

2. Federal Tax Law as Administrative Law 23

a. • Congressional Delegation of Rulemaking 23

b. Treasury Regulations 24

c. Revenue Rulings 28

d. Private Letter Rulings 29

e. Other IRS Output 30

Problem 31

3. Federal Tax Disputes in the Courts 31

Problems 32

TABLE OF CONTENTSChapter 2 BASIC INCOME TAX PRINCIPLES 33

A. EVOLUTION OF "PERSONAL INCOME" AS A CONCEPT 33

1. Personal Income vs. National Income 33

2. Competing Notions of Personal Income 33

a. Trust Accounting Income 34

b. Business Accounting Income 34

c. Income as Return on Capital or Labor 34

d. Simons Income 35

e. Ability-to-pay income 35

3. Some Highlights in the Evolution of the Income Tax 36

4. Ability-to-Pay Net Income as a Useful Model for Conceptualizing theIncome Tax 38

5. The Income Tax Base and its Effect 38

B. MEASURING NET INCOME 39

1. Measuring Changes in Net Wealth: The Realization Principle 392. Measuring Consumption: Personal Consumption as a Deduction-

Disallowance Principle 403. The Resulting Structure of the Income Computation 41

Notes 42

C. THE TAX BASE UNDER THE CODE 431. Gross Income Overview 43

2. Gain and Loss from Property Dispositions . 443. Capitalization and Basis 45

Problem 48Notes 48

4. The Character of Gain and Loss from Property: Capital vs. Ordinary . . . 50Problems 53Note' 53

5. The Borrowing Exclusion 54Problem 55

* Note 556. Deductions under the Code . 55

a. General Rules 55b. Business and Investment Expenses 56c. Business and Investment Losses 57d. Depreciation of Business and Investment Property 58

Problems 61Notes 61

D. COMPUTING AND PAYING THE INCOME TAX 631. Computing the Federal Income Tax of Individuals 63

a. Adjusted Gross Income 63

vi

TABLE OF CONTENTSb. Deductions for Personal and Dependency Exemptions 66

c. The Standard Deduction 66

d. Itemized Deductions 66

2. The Alternative Minimum Tax 68

3. Returns, Payments, and Tax Controversies 69

Problems : . 70

Chapter 3 TAX POLICY: EVALUATING TAX SYSTEMS ANDPROVISIONS 71

A. FAIRNESS NORMS 72

1. Formal Fairness: The Concept of Horizontal Equity 72

2. Vertical Equity . . 733. Norms of Substantive Tax Fairness 73

a. Equal-Burden Principle 74b. Benefit Principle 74c. Consumption Principle '. . 75d. The Ability-to-Pay Principle i 76

B. DISTRIBUTIVE NORMS _ > 77C. ECONOMIC NORMS 78D. THE "TAX EXPENDITURE" CONCEPT '. . 81

Problems 83

Chapter 4 RATES AND ALLOWANCES FOR BASICMAINTENANCE 85

A. RATE STRUCTURES :. ; . 851. Denning Progressivity . • 85

2. Rationales for Progressivity ; 87a. Objective Ability to Pay 87b. Sacrifice Theory . 88

3. A Brief History of Rates 90Notes . 90

B. FILING STATUS 911. The Marginal Rate Concept 912. Tax Pros and Cons of Marriage 923. A Brief History of Filing Status 944. Equity Among Individuals or Married Couples? . 96

Notes 96Problems 97

C. * ALLOWANCES OFF THE BOTTOM 971. The Standard Deduction 982. Deduction for Personal Exemption . 98

vii

TABLE OF CONTENTS3. Deduction for Dependency Exemptions 99

Revenue Ruling 77-282 100

4. The Tax Treatment of Dependents 101

Notes 102

Problem 103

D. WELFARE TAX EXPENDITURES 104

1. The Child Tax Credit 104

2. The Earned Income Tax Credit-r 104

3. The Household and Dependent Care Credit 105

4. Other Non-Business Credits 105

Problem 106

Notes 106

Chapter 5 DEDUCTIONS FOR OFF-THE-BOTTOM PERSONALEXPENSES 109

A. RELATION OF OFF-THE-BOTTOM PERSONAL DEDUCTIONS TOOFF-THE-BOTTOM ALLOWANCES 109

B. DEDUCTION FOR ALIMONY \ . 110

1. Tax-Common-Law Background 110

2. Enactment of §§ 71 and215 I l l

3. Rationale I l l

4. Tax Alimony Denned . 112

5. Front-Loaded Alimony Payments . 1126. Alimony trusts 1137. Property Transfers Incident to Divorce ; ' 113

Notes 114Problems 115

C. DEDUCTIONS RELATING TO TAXES PAID , 1161. Tax Payments in the Absence of § 164 116

2. What Does § 164 Accomplish? 1163. Property Taxes on Real Estate Sold During the Year 117

4. Federal Taxes 1185. Foreign Taxes 1186. Status of Deduction for Taxes 1197. Is the § 164 Deduction Justified? 119

a. Simons Income Concept 119b. Ability-to-Pay Income 120c. Federalism 121

* d. Distortionary Effects 122e. Conclusion 122

Notes 122

viii

TABLE OF CONTENTSProblems . 124

8. Expenses Relating to the Determination of Tax Liability 124

a. Background 124b. . The Expanded Scope of § 212(3) 125

c. Possible Doctrinal Rationales for an Expanded § 212(3) 126d. Is There Any Policy Rationale for § 212(3)? 127

Notes . 1 2 7

Problem . V , . 128D. THE MEDICAL EXPENSE DEDUCTION 128

1. Whatls "Medical Care"? .'. 1282. Medical Care Capital Expenditures 1293. . Who Obtains the Deduction? ; 1294. Accounting for Medical Expenses ... ..-; ; 1305. Status as Itemized Deduction 130

6. Relation to Other Deduction Provisions 1307. Policy Analysis 1308. Overview of the Taxation of Health Care 132

a. Unreimbursed Health Care . , 132b. Health Care Covered by Self-Purchased Insurance 132c. Employer-Provided Health Insurance . 132d. Self-Employed Health Insurance 133e. Self-Purchased Insurance Through Health Savings Accounts

(HSAs) , 1 3 3Notes : 133

Problems 134

Part Two INCOME TAXATION vs. CONSUMPTION TAXATION . . . 137

Chapter 6 VIEWING THE INCOME TAX THROUGH ACONSUMPTION TAX LENS . . . . . • • 139

A. DESCRIPTION OF THE MAJOR CONSUMPTION TAX REGIMES . . 1391. Retail Sales Tax and Value Added Tax ,. . . 1392. Wage Tax 141

3. Cash Flow Consumption Tax 142Problem 143

4. Comparison of Retail Sales Tax, Wage Tax, and Cash FlowConsumption Tax 143

Problem 145

B. AN INTRODUCTION TO THE TIME VALUE OF MONEY 145

V. Compound-Interest Analysis 1452. Present-Value Analysis : 146

C. REPLACING THE INCOME TAX WITH A CONSUMPTION TAX . . . 147

ix

TABLE OF CONTENTS1. Effect on Savings 147

2. Distributional Considerations . . . •: 150

3. Tax Justice Norms 151

4. Pragmatic Norms 152

Problem 153

D. FINANCIAL ANALYSIS AND THE TAXATION OF CAPITALINCOME 154

E. SOME CONSUMPTION TAX FEATURES OF CURRENT LAW 156

1. Savings Vehicles 156

2. Qualified Retirement Vehicles 157

3. Section 179 Deduction and Accelerated Depreciation 157

4. Exclusion for Interest on State and Local Bonds 158

5. Gain on Personal Residence : 158

Problem 159

6. Unrealized Appreciation as Mimicking a Consumption Tax Result . . . 159

a. Sole Proprietorship Business Scenario 159

b. Land Purchase Scenario 160

c. The Lesson 161

F. THE HYBRID TAX ANDS ITS EFFECTS 161

1. What income tax? 161

2. Tax Arbitrage 162

3. Possible Distortionary Effects of a Hybrid Tax 163

Problem . 164

Chapter 7 THE CAPITALIZATION PRINCIPLE IN PRACTICE . • 165

A. CREATION OF INTANGIBLE ASSETS AND BENEFITS '. . 1651. Intangible Benefits 165

INDOPCO, Inc. v. Commissioner 165

Problems 1682. The Post-INDOPCO Intangible Asset Regulations 168

Problems •..-. . 1693. Advertising and Goodwill . . 169

Notes 170Problem 170

B. COSTS OF PRODUCING TANGIBLE ASSETS (INCLUDINGINVENTORY) 170

Commissioner v. Idaho Power Co 171

Problems 174

C. COSTS RELATED TO ASSET ACQUISITIONS 1741. Transaction Costs 174

Woodward v. Commissioner 175

x

TABLE OF CONTENTSProblems . . 177

2. Costs Preliminary to the Transaction 177

a. Search Costs 177


b. Evaluation Costs 180

Notes 180

3. Development Costs 181

4. Pre-Opening Costs '\ . : r:' 181

Note 182

Problems 182

D. THE REPAIR EXPENDITURE EXCEPTION 183

American Bemberg Corp. v. Commissioner 184

Problems 187

Part Three DIFFERENTIATING AMONG THE BUSINESS,INVESTMENT, AND PERSONAL SPHERES 189

Chapter 8 THE BASIC FRAMEWORK GOVERNING BUSINESSAND INVESTMENT DEDUCTIONS > 191

A. THE DISTINCTION BETWEEN BUSINESS AND INVESTMENT . . . 1911. How the Code Came to Allow Deductions for the Production of

Nonbusiness Income 191

2. Significance of Distinction between Business and Investment 1923. Distinguishing between Business and nonbusiness Income Production . 193

Notes 195Problem .197

B. THE BASIC REQUIREMENTS OF DEDUCTIBILITY 1971. The Welch Case 197

Welch v. Helvering . . : 1972. The Outlay Must Be an "Expense"? 1993. The Expense Must Be Ordinary 2004. And Necessary . 200

5. In Carrying on a Trade, Business, or Investment Activity 201Notes 203Problems 203

C. CONNECTING EXPENSES TO AN INCOME-PRODUCINGACTIVITY 204

United States v. Gilmore J 204. Notes 207

Problems .* s 208

D. LIMITATIONS ON DEDUCTIONS . . 2081. Public Policy Disallowance Rules 208

xi

TABLE OF CONTENTS2. Political Expenditures 210

a. Costs of Lobbying Government 210

b. Campaign Costs of Political Candidates 210

3. Excessive Compensation 211

4. Expenses Allocable to Exempt Income 211

Manocchio v. Commissioner 212

Notes 213

Problems '. ., -r 214

Chapter 9 DEFINING THE PERSONAL REALM: OF HUMANCAPITAL 215

A. WHAT IS "HUMAN CAPITAL"? 215

B. DISTINGUISHING HUMAN CAPITAL FROM CONVENTIONALCAPITAL 215

C. DISTINGUISHING HUMAN CAPITAL FROM GOODWILL . . . 217D. EDUCATION COSTS 218

1. Deductibility under the Regulations , 218Sharon v. Commissioner 219

2. Tax Expenditures for Education 222

E. JOB-SEEKING COSTS .' 223Primuth v. Commissioner 223

F. MOVING COSTS 225Notes . 226

Problems 227

Chapter 10 DUAL-PURPOSE OUTLAYS 229

A. PERSONAL-USE PROPERTY WITH APPRECIATION POTENTIAL . 229

B. NOT-FOR-PROFIT ACTIVITIES 229Estate of Power v. Commissioner 232


C. GAMBLING LOSSES 238Note 239Problem . 239

D. COMMUTING 239Commissioner v. Flowers 240

E. WORK CLOTHING 241F. CHILD CARE 241

G. BUSINESS-SETTING MEALS NOT INCURRED IN A TRAVEL ORENTERTAINMENT MODE 242

Moss v. Commissioner 242

xii

TABLE OF CONTENTSNotes 244

Problems 246

Chapter 11 ALLOCATING COSTS BETWEEN THE INCOME-PRODUCTION AND PERSONAL REALMS 247

A. ALLOCATION ACCORDING TO USE OF ASSETS : 247

1. Allocations by Space 247

2. Allocations by Time '.'.".". 247

3. Converted-Use Property 248

Problem 250

B. STATUTORY OVERRIDES OF ALLOCATION RULES 250

1. Listed Property 250

2. Home Offices 250

a. When Home Office Deductions Are Allowed at All 251

b. Confinement of Home Office Deductions to the Home Office

Business 252

3. Vacation Homes 253

a. No Personal Use ; . . . . 253

b. Minimal Personal Use Combined with Significant Rental Use . . . . . 254c. Minimal Rental Use 254

d. Non-Minimal Rental and Personal Use . . . . " ." 254

e. Rental of Principal Residence ' 254Notes / 255Problems 255

C. TRAVEL AND ENTERTAINMENT (T & E) EXPENSES 2561. Transporting Work Tools . . . . . : 2562. Business Transportation . 2573. Exceptions to the Nondeductibility of Commuting Expenses 258

Revenue Ruling 99-7 258Problems 259

4. Travel Meals and Lodging 260

a. Sleep-or-Rest Rule for Business Travel Meals 260United States v. Correll 261

b. "Away from Home in the Pursuit of a Trade or Business" 263i. Temporary vs. indefinite stay 263ii. Two business locations 264iii. Spouses having different business locations 264iv. Itinerant workers 266

Notes . 267Problem 268

5. Business Entertainment Costs 268

xiii

TABLE OF CONTENTSa. Section 274 Disallowance Rules 269

b. Exceptions to § 274 270

6. Substantiation Requirement 271

Notes 271

Problems 272

Part Four GROSS INCOME FROM MARKET TRANSACTIONS . 275

Chapter 12 FORMS OF COMPENSATION INCOME 277

A. DISGUISED COMPENSATION 277Old Colony Trust Company v. Commissioner 278


B. EMPLOYEE FRINGE BENEFITS 2811. Tax-Common-Law Exclusions 282

a. Working Conditions 282

b. Meals and Lodging for the Convenience of the Employer , 283c. Meals and Lodging under § 119 : 284


2. Other Fringe Benefits Excluded by Statute 286Notes 288

Problems 289

C. POLICY CONSIDERATIONS 290Notes 291Problem 292

Chapter 13 CAN IN-KIND CONSUMPTION BE "RESIDUALGROSS INCOME"? 293

A. IN-KIND CONSUMPTION BENEFITS UNDER TAX THEORY 293

B. NONMARKETBENEFITS 2951. General Psychic Benefits . 2952. Imputed Income from Self-Provided Services 2963. Imputed Income from Ownership of Consumer Assets 298

Notes 299C. PERSONAL BENEFITS PROVIDED BY ANOTHER PARTY 300

1. Benefits Incidental to Business Activity 300United States v. Gotcher 301Notes 305

Problems 3062. Free Samples 307

xiv

TABLE OF CONTENTSHaverly v. United States 307

Notes 309

Problem 310

PartFive WEALTH TRANSFERS 311

Chapter 14 RECOVERIES FOR PERSONAL INJURY AND OTHERWINDFALL RECEIPTS 313

A. HISTORY AND POSSIBLE RATIONALES OF SECTION 104 3131. Background: Recoveries in Commercial Litigation 3132. Personal Injury Recoveries from Inception to Glenshaw Glass 3143. Dubious Internal-to-Tax Exclusionary Theories 3154. Glenshaw Glass 316

Commissioner v. Glenshaw Glass Co 3175. Evolution of § 104(a)(2) from 1955 to the Present 318

B. TAXES AND TORT POLICY 320C. SECTION 104 IN OPERATION '. 321

D. LEGAL FEES INCURRED TO OBTAIN DAMAGES \ 323Notes 324Problems 326

E. OTHER WINDFALLS '. 327Problems 329

Chapter 15 GRATUITOUS TRANSFERS 331

A. TAXING GRATUITOUS TRANSFERS UNDER THE INCOME TAX . 3311. The Statutory Pattern ' : 331

a. Exclusion for Gratuitous Receipts 331b. Nondeductibility of Gratuitous Transfers 333

2. Transfers In-Kind '..... 334a. Income from Gratuitous Transfers 334b. Gratuitous Transfers Are Not Gain or Loss Recognition Events . . . . 335c. Basis Rules 335

Notes : . . . :'. 337

Problems 3393. What Is a Gift? 340

Commissioner v. Duberstein 340Notes •.-....• 344Problems 346

4. A Detour: The Role of Substantive Tax Doctrine in Criminal Tax FraudProsecutions 347

United States v. Harris 347

xv

TABLE OF CONTENTSNotes 349

Problems 350

5. Government Welfare Benefits 351

Notes 351

B. LIFE INSURANCE . 352

1. Income Taxation of Life Insurance Proceeds 352

2. What Are "Life Insurance Proceeds"? . . . 354

C. SURVIVOR BENEFITS UNDER ANNUITIES AND RETIREMENTPLANS 354

Notes 355

Problems 356D. SPIN-OFFS FROM SECTION 102 DEALING WITH PRIZES,

AWARDS, AND SCHOLARSHIPS 3561. Prizes and Awards 356

Problems 3582. Scholarships 3583. Reduced-Cost Education for Employees of Educational Institutions . . . 359

Notes - 360Problems 361

Chapter 16 CHARITABLE CONTRIBUTIONS 363

A. WHAT IS A GIFT OR CONTRIBUTION? 363

B. THE DONEE ORGANIZATION . 3661. Classification of Organizations 3662. Taxation of Exempt Organizations 3673. Deduction-Eligible Donees 367

C. MECHANICS OF THE DEDUCTION . . 3681. Nondeductible Gifts 3682. Valuation 369

3. Cut-Down Rules for Appreciated Property 3704. Deduction Ceilings 371


D. IS THE CHARITABLE DEDUCTION JUSTIFIED? 373Notes 375

Chapter 17 INCOME-SHIFTING STRATEGIES 377

A. INCOME ATTRIBUTION 377

4. Income from Property 3772. Income from Services 377

Lucas v. Earl 378

xvi

TABLE OF CONTENTS3. Who Is the Real Earner? : 379

4. Who Is the Real Owner of Income-Producing Property? 379

Helvering v. Clifford 381

B. OTHER JUDICIAL DOCTRINES PREVENTING INCOMEASSIGNMENTS 383

1. Nontrust Retained-Reversion Transfers 383

2. Nontrust Gifts of Accrued but Unpaid Income Rights . 384

C. ATTRIBUTION OF DEDUCTIONS^ 385

Notes 386

Problems 387

D. NONTRUST STRATEGIES FOR SHIFTING INCOME 388

1. Gifts of Income-Producing Property to Minors: The Kiddie Tax 389

2. Below-Market Gift Loans 390

Problems 391

3. Paying Salary to the Natural Object of One's Bounty 391

Fritschle v. Commissioner 392

Problems 393

4. Gifts of Interests in Entities Carrying on a Services Business . .v 394

a. Family Partnerships 394

b. Family Subchapter S Corporations 396

c. Family C Corporations 396

Problem 397

E. INCOME SHIFTING THROUGH TRUSTS 397

1. The Trust as an Accounting Entity 397

2. Subchapter J Trusts 398

3. Grantor Trusts 402

4. Beneficiary-Owned Trusts 403

5. Use of Trusts in Family Income Tax Planning 403

Problems 404

F. INCOME TAXATION OF ESTATES AND SURVIVORSHIPRIGHTS 405

1. Transfers at Death of Accrued but Unpaid Income Rights 4052. Income Taxation of Estates . . 406


Part Six BORROWING, LENDING, AND INTEREST 409

Chapter 18 BORROWING, LENDING, AND INTEREST 411

A. "STRAIGHT" BORROWING AND LOAN REPAYMENTTRANSACTIONS 411

xvii

TABLE OF CONTENTSB. BELOW-MARKET LOANS 413

Problems 415

C. WHAT COUNTS AS A BORROWING 416

1. Contingent Repayment Obligations 416

North American Oil Consolidated v. Burnet 416

Problem 419

2. Phantom Repayment Obligations 420

James v. United States . r.~T. 420

Problems 422

D. INTEREST EXPENSE 422

1. Interest as an Expense 423

2. Incurred to Produce Income 423

3. Excess Investment Interest 424

4. Consumer Interest Generally 425

5. Consumer Interest on Debt Secured by a Personal Residence 426

Problems 426

6. Sorting Interest into Categories 427

Chapter 19 CANCELLATION-OF-DEBT INCOME 429

A. SATISFACTION OF LIABILITIES 429

1. Satisfaction by the Debtor 429

2. Third-Party Satisfaction of Debt 431

Problems . . 431

B. COD INCOME . . 432

1. A Doctrine in Search of a Theory 432

a. The Balance-Sheet Approach 432

Notes 435

Problem 435

b. The Inconsistent-Events Theory 435

c. Evaluation of the Theories 436

d. Where Is the Law Headed? '. 437

Notes 438

2. The Disputed-Debt Doctrine , 439

Zarin v. Commissioner 439

Zarin v. Commissioner 442

Notes 445

Problems 445

G. SECTION 108 447

Problems 448

xvin

TABLE OF CONTENTSChapter 20 DEBT AND PROPERTY 451

A. THE EFFECT OF DEBT ON BASIS 451

Problem 454

B. REDUCTION IN ACQUISITION DEBT 454

1. Third-Party Debt 454


2. Two-Party Debt ,. . . 457

Notes 457

Problem 458

C. THE DISPOSITION OF DEBT-ENCUMBERED PROPERTY 458

1. Positive-Equity Property 459

Problems 461

2. Negative-Equity Property 461

a. Nonrecourse Debt 462

Commissioner v. Tufts 463

b. Recourse Debt 467


3. Unpaid Interest 468

Note 469

Problems 469

Chapter 21 TAX SHELTERS 471

A. WHAT'S A/TAX SHELTER"? 471

B. ROLE OF COURTS IN ATTACKING "ILLEGITIMATE"ARRANGEMENTS 474

1. Sham Transactions 474

Kneisch v. United States 474

2. Business Purpose 476

3. Economic Substance 477

4. Codification of the Economic Substance Doctrine 479

Problem 480

C. NONRECOURSE DEBT IN TAX SHELTERS 480

. 1. Inflated Two-Party Nonrecourse Debt 480

2. Limited Partnerships 483

3. At-Risk Rules 485

D. SECTION 469 AND PASSIVE.LOSSES >. . . 486

Notes 488

Problem 488

xix

TABLE OF CONTENTS

Part Seven REALIZATION AND RECOGNITION 491

Chapter 22 REALIZATION OF GROSS INCOME 493

A. NONMARKET TRANSACTIONS 493

1. Obtaining the Bounty of Nature 493

2. Changes in Value Brought about by External Events 494

3. Subdividing Property -.: 494

4. The Ripening of Existing Rights and Interests 494

5. The Exercise of Options and Conversion Privileges 495

6. Repossessing Sold Property 496

Notes 498

Problems 499

B. WHEN DOES A TAXABLE EXCHANGE OCCUR? 499

1. Stock Dividends and Stock Splits 500

2. Modification of Debt Instruments 502

3. Exchanges of Virtually Identical Properties 503

Notes '• 504

Problem 506

4. Like-Kind Exchanges 506

a. Eligibility for § 1031 507

b. Mechanics of § 1031 508

Notes I. . 511

Problem 512

C. LESSEE IMPROVEMENTS 512

M. E . B l a t t Co. v. United States . . . . . ' : 5 1 3

Helvering v. Bruun . . 515

Notes 516

D. BARGAIN PURCHASES OFPROPERTY 518

1. Commercial Bargain Purchases 518

Notes , 519

2. Non-Arm's-Length Bargain Purchases 520

Problems 521

3. Employee Stock Options 522

Commissioner v. Smith 522

E. NONVESTED PROPERTY TRANSFERS UNDER SECTION 83 526

Notes 528

Problems 529

xx

TABLE OF CONTENTSChapter 23 TAX ACCOUNTING METHODS 531

A. ROLE OF CASH AND ACCRUAL ACCOUNTING METHODS 531

1. Inventory Accounting 531

2. What Issues Are Affected by Tax Accounting Methods? 532

3. The Cash and Accrual Approaches in a Nutshell 534

4. Accounting Methods and Bad Debt Losses 535

Revenue Ruling 93-27 .'. 536

5. Which Method of Accounting Does a Taxpayer Use? 538

Notes 539

Problems 540

B. CASH-METHOD DOCTRINE 541

1. The Cash-Equivalency Doctrine 541

a. Checks 541

b. Contractual Promises to Make Future Payments 542c. Promissory Notes 542

d. Credit Card Transactions 544Revenue Ruling 78-38 . . . . 544

e. Effect of § 83 ". 5452. The Constructive-Receipt Doctrine . . 545

Reedv. Commissioner 5463. The Economic-Benefit Doctrine '. 5494. Funded Deferred Compensation under the Code , 5505. Section 409A , . 550


C. THE ACCRUAL METHOD 5541. The All-Events Test 554

a. Routine Applications 554b. Some Leading Accrual Cases 555

Notes 558

Problem . , '....• 5592. Economic-Performance Test 559

Note .".- 560

Problem . ; 5603. Tax Accounting Versus Financial Accounting 561

RCA Corporation v. United States 562"•' Notes . '. • 566

Problem 567

D. ACCOUNTING FOR DEFERRED-PAYMENT PROPERTY SALES . . 5671. Gains and Losses under § 1001 <. 568

2. The Installment Method 570

xxi

TABLE OF CONTENTSa. Scope of Installment Method 570

b. Installment Method Mechanics 571

c. Section 453A 573

d. Disguised Interest 573

e. Disposition of Installment Obligations 575

3. Open-Transaction Method for Contingent Payment Sales 576

4. Deferred Sales Pursuant to Put and Call Options 578

Notes r . . . . . . . ? 580

Problems 581

Chapter 24 REALIZATION OF LOSS ON THE DESTRUCTIONOR THEFT OF PROPERTY 583

A. THE DEDUCTION FOR PERSONAL CASUALTY AND THEFTLOSSES 583

1. What Is a Casualty or Theft? 583

2. Is the § 165(c)(3) Deduction Justified? . 5843. Limitations on the § 165(c)(3) Deduction 586

Notes ...':- 587B. WHEN IS A LOSS SUSTAINED? 588C. DETERMINING THE AMOUNT OF THE LOSS (OR GAIN) . . . 589

1. The Loss Amount 5892. Effect of Recovery . : . . 590

3. Tax Treatment of Casualty Insurance Premiums ; . . 591Notes . 591Problem 592

D. GAINS FROM INVOLUNTARY CONVERSIONS , 5931. Operation of § 1033 5932. Interaction of § 1033 with § 121 5943. Character of Recognized Involuntary Conversion Gains and Losses . . . 595

Note 596Problems 596

Chapter 25 CAPITAL GAINS AND LOSSES 597

A. DEFINING CAPITAL GAINS AND LOSSES 5971. The "Sale-or-Exchange" Requirement 5972. "Capital Asset" 601

a. Overview of the Statutory Exceptions 601

b. The "Dealer Property" Exception 602Byram v. United States . . ; 602

c. Hedging Transactions 605

d. The Arrowsmith Doctrine 606

xxii

TABLE OF CONTENTSArrowsmith v. Commissioner 606

e. Rights to Ordinary Income 608

Notes 611

Problems 612

B. DEPRECIATION RECAPTURE AND SECTION 1231 613

1. Depreciation Recapture 613

2. Section 1231 615

Notes \' . -r r r 616

Problem 616

C. POLICY CONSIDERATIONS 617

D. EXCESS CAPITAL LOSSES AND NET CAPITAL GAIN 620

1. Excess Capital Losses 621

Problem 621

2. Net Capital Gain 622

Notes '. 622

3. Planning Considerations 623

Problem 624

Part Eight CAPITAL RECOVERY APART FROM SALES ANDDISPOSITIONS '.. 625

Chapter 26 RECOVERIES OF EXPENSE ITEMS: THE EFFECT OFANNUAL ACCOUNTING ON BASIS AND BASISRECOVERY 627

A. THE ANNUAL ACCOUNTING PRINCIPLE 6271. The Taxable Year . 627

2. Unfinished Business 628Burnet v. Sanford & Brooks Co 628

3. Net Operating Loss Carryovers 6304. Accounting for Long-Term Contracts 630

Notes 631B. TRANSACTIONAL ACCOUNTING FOR RECOVERIES 631

1. Second-Party Refund of Expenses 6322. Third-Party Customer Rebates 633

Revenue Ruling 76-96 6343. Third-Party Expense Reimbursements . 635

Clark v. Commissioner 6354. Medical Insurance Reimbursements 6365. Liability Insurance 637


xxiii

TABLE OF CONTENTS6. Figuring the Taxpayer's Basis in a Recovery 640

a. The Tax Benefit Rule 640

Dobson v. Commissioner 640

b. The Basis-Ordering Rules of § 111 643

7. The "Inconsistent Events" Rule ' 645

Notes 646

Problems 647

8. Refunds of Prior Receipts 647

a. . The Misnamed "Claim-of-Right" Doctrine 647

. b. Section 1341 648

Notes 650

Problems 650

C. TRANSACTIONAL ERRORS AND THE STATUTE OFLIMITATIONS 651

1. Basic Procedures Involving Tax Returns 651a. The Filing of the Return 651

b. Amended Returns • • •• 652

c. Audit and its Aftermath 653

2. Tax Statutes of Limitations 653Notes 654

3. Transactional Error-Correcting Adjustments 654a. Recovery of Erroneously Deducted Amounts 655

Hughes & Luce v. Commissioner 655b. Repayment of Erroneously Excluded Amounts 657

c. Does a Basis Exist in Erroneously Excluded In-Kind Income? 657d. Duty of Consistency 657e. Estoppel , 658f. Equitable Recoupment 658

4. The Mitigation Provisions 6595. Effect of Judgments in Tax Litigation 660

Problems 661

Chapter 27 THE TAXATION OF FINANCIAL INVESTMENTS . . . 663

A. CONVENTIONAL DEBT OBLIGATIONS 6641. Identifying Principal and Interest 664

a. Interest-Only Obligations 664b. The Theory: Realized Changes in Value Due Solely to the Passage

of.Time 665

c. Level-Payment Obligations 6672. Timing of Interest Inclusions and Deductions 669

Note 670

xxiv

TABLE OF CONTENTSProblems 670

B. DISCOUNT AND PREMIUM 671

1. Original Issue Discount . . 671

2. Market Discount 675

3. Bond Premium . . . 676

Problem 677

C. ANNUITIES •: 677D. TAXATION OF LIFE INSURANCE CONTRACTS BEFORE THE

INSURED'S DEATH 679


Chapter 28 DEPRECIATION 683

A. NORMATIVE DEPRECIATION UNDER AN INCOME TAX 6831. Depreciation under the "Finality" View of Realization 683

2. Depreciation under the "Liquidity" View of Realization . 6843. Cost Recovery under the Code as a Tax Expenditure 686

B. WHAT IS DEPRECIABLE? >. . . . . 687Simon v. Commissioner 687

C. WHO TAKES DEPRECIATION? .-. 6911. Seller-Financed Sale vs. Lease of Tangible Personal Property 6922. Seller-Financed Sale vs. Lease of Real Property 693


3. Sale vs. License of Intangibles 697Fawick v. Commissioner •'. 699Problems 701

D. CALCULATING DEPRECIATION UNDER THE CODE 7021. Depreciation of Tangible Personal Property 702

a. Pre-Depreciation Cost Recovery 702b. Depreciation Proper 703c. Section 280F Limitations . . . '. 705

2. Depreciation of Real Property . : 7053. Amortization of Intangibles 706

4. Effect of Depreciation on Basis 708Problems 708

Chapter 29 THE DISPOSITION OF A PART OF THE WHOLE 711

A. DISPOSITION OF PHYSICAL COMPONENTS 7111. Disposition of an Aggregate of Assets 711

Problem 713

xxv

TABLE OF CONTENTS2. , Depletion of Natural Deposits 713

a. Cost Depletion 713b. Percentage Depletion 714c. Who Is Entitled to Depletion? 714

O'Connor v. Commissioner 715Notes 719Problem 719

3. Recoveries for Unidentifiable Portions of the Whole 720

Problems 721B. TRANSACTIONS INVOLVING TEMPORAL INTERESTS . 722

1. Carve-Out Sales 722Hort v. Commissioner 722Notes ( 726

2. Investing in Temporal Interests 7273. Interests Obtained by Gratuitous Transfer 728

Problems 730

Appendix 731

Table of Cases TC-1

Table of Statutes TS-1

Index 1-1

XXVI

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